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July 22, 2010 – Comments (3)

Suddenly, there is an acute interest in the deflation topic. Case in point: two articles in two days appeared on seekingalpha, and both articles are quite thoughtful, at least by seekingalpha standards. One of them, titled "Why Bernanke might choose deflation", gives a convincing answer: because it will allow the government (and everyone else for that matter) refinance the debts very cheaply. Wouldn't it be nice if we could increase debt-to-GDP to 200% with impunity? So there is a certain logic here. The other article, titled "Fed failing both mandates", is a typical whining of a homeowner that is best summed us as "please, uncle Benny, I want my ATM back", but it does a good job of illustrating the mentality that has shaped our course so far, and will keep doing so for decades if not forever. 

So deflation or inflation? My answer is, "deflation talk and then inflation". The plan is to inflate away all the debt, but first to make a deceptive inroad into deflationary territory that will send the lemmings running in the wrong direction. So we'll keep telling our foreign friends, "look, we are deflating", until they buy up all our 30-year T-bonds with a 3% coupon rate. And we'll be telling them, "don't you worry about repayment, we'll be printing AND deflating. We'll print to pay you, and deflate to guarantee your investment". And so we'll be having this 6-9 month period during which prices will be essentially flat, but the media will be full of deflation stories. When deflation talk peaks, that will be the final signal to jump into TIPS, real estate, stocks, and, if you're stupid, commodities. 

The inflation will come suddenly out of nowhere - prices could jump during a period as short as 3-4 months. Suddenly, velocity of money will jump back to the pre-crisis level, and that velocity will now be leveraged against the Fed's balance sheet that had been doubled by Bernanke in 2008-2010. This doesn't mean CPI will double in one year. Sure enough, Bernanke will increase reserve requirements, constrain lending, maybe even raise the funds rate to 0.25% or 0.5%, the statistical office will do its job well, inflation will take its time to percolate through the economy, Chinese lead-painted toys will remain cheap, etc. etc. But we'll definitely have 4% to 5% inflation for a decade or so.

It never pays to follow the herd when it's been exploring a hot new trend for a while, but it pays to follow the herd at the early stage of the trend. So I think for the next few months at least deflation hedges will be all the rage. Particularly, junk bonds and preferreds will be trading much higher than they deserve. Eventually, paper bugs will be in for a rude awakening. But while this infatuation with paper continues, there is no rush to sell fixed-income securities - yet. 


3 Comments – Post Your Own

#1) On July 22, 2010 at 8:34 PM, XXX222 (< 20) wrote:

I use a rather unorthodox of measuring inflation/deflation. I compare the price of a 12 pack of Red Bull with the last time I saw it. I've been doing it since early 2009. I'm not sure how accurate it is, but I've observed a gradual increase in the price since about 2 months ago. It's highest price was around $21.00 before tax. Now it's 20.01 the last time I checked today. I know there are a ton of other factors affecting it's price, like consumer demand and how badly the store wants to clear out inventory, but I prefer my method to sifting through the Fed's byzantine reports.

As for your analysis, I agree, I think greater inflation is coming. Deflation is not the friend of government.

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#2) On July 22, 2010 at 11:53 PM, awallejr (35.47) wrote:

 "and, if you're stupid, commodities"

You'd be nuts not to be in commodities.  China and India.  It's about supply and demand in the end.  Case closed.

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#3) On July 23, 2010 at 12:33 AM, russiangambit (28.69) wrote:

To launch into inflation the  velocity of money needs to hit the escape velocity, so to speak. Last 2-3 months the are not getting it, we are slowing down instead. In the end, the outcome is dependent 100% on the housing market because the housing market is so big. Housing  is starting to fll again.

I don't know what FED can do to speed up the velocity. The current situation is strating look very much like the japanese conundrum where even a supreeasy monetary policy doesn't spur investment. Explain to me how is US going to solve it?

Actully, deflation expectations are as scary as inflation expectitions, and may be even more. Once people are convinced of deflation the flow of money will stop. It is in the best interest of the FED to nurture the inflation expectations at this point. But on the other hand if they do that they risk the popular outrage. They are walking a very tight rope. I don't think they are paid enough to be that suicidal.

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