Inflation or Deflation: Which Is It?

Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.

~ Sam Ewing

Will we have inflation or deflation? This is probably the most important question facing investors right now. There are plenty of smart people who argue convincingly for each. All of them make very good points. But who is right? If you asked me if we should be worried about inflation or deflation, I would probably answer as follows: Yes.

Inflation & Deflation Defined

You know you’re going to have a hard time answering a question correctly when the experts can’t even agree on the basic definition of the terms of the problem. Not only is there a huge and varied debate in the financial community about whether inflation, deflation, both, or neither is a threat, many analysts can’t even agree on what they are.

Inflation is commonly defined as a general rise in the price of goods and services. Deflation, then, is a general fall in the prices of goods and services. But there is a branch of economics (the Austrian school) that contends that price movements are merely the effects of inflation or deflation, and not defining factors.

Rather, those from the Austrian school of economics contend that inflation and deflation are purely monetary phenomena. An increase in the money supply leads to inflation. A decrease in the money supply leads to deflation. Inflation does lead to higher prices, but they do not define it. The converse is true for deflation. If you’re interested in delving much deeper into this The Daily Capitalist is currently 2 parts into a 4-part series analyzing the very question that I’m posing here today.

Flation It Is . . .

In some cases, the chief differentiating factor between the inflationists and the deflationists is simply a matter of timing, with some predicting inflation sooner and others seeing deflationary conditions first and inflation many years down the road. It’s been my contention for some time now that we will experience a bout of deflation, followed by a period of inflation – maybe even hyperinflation or stagflation. Either way, we’re in for a lot of flation. I don’t think that’s actually a word, but maybe it should be. Perhaps the years between 2000-2025 will eventually be called “The Great Flation“. You read it here first.

We are currently in a deflationary environment. Bond yields across various maturities in many countries are reaching multi-year lows (except for the countries with giant debt problems – Greece, Portugal, Spain, Hungary, etc.). The housing market in the U.S. is rolling over again. Weekly ECRI leading indicators have been weakening, indicating that further economic weakness is around the corner.

Bearish SocGen strategist Albert Edwards says that “we are now walking on the deflationary quicksand that will inevitably suck us toward total fiscal and financial ruin. . . we are only one recession away from Japanese-style deflation.” I know. That doesn’t sound very good. If you want a rosier economic forecast, try out the one from BCA economist Chen Zhao who says that a double-dip recession is unlikely and that fears about the European economy are overblown. (Thanks to Larry MacDonald for pointing me to that link.)

In Search of Goldilocks

Too much inflation is not good because the prices of goods and services can rise quickly, eroding the purchasing power of money. At extremes, it can lead consumers to hoard goods, fearing further price increases. This can in turn lead to shortages of goods and further price increases.

Too much deflation isn’t good either. While it can lead to greater purchasing power for cash, it can also result in a deflationary spiral. This is where lower prices lead to lower production, lower wages and lower demand. This in turn leads to even lower prices, and the spiral continues. Deflationary periods are usually associated with recessions and unemployment.

A Goldilocks economy is one where there is a balance between inflation and deflation. An inflation rate of 2% or so seems to be “just right” according to many central bankers. Is 2% just right? I don’t know, but I’m pretty sure nothing is just right at the moment.

Global debt levels, government/central bank interference and greedy goings-on at corporations worldwide have conspired to contaminate the porridge. Many consider it tainted. It’s over-processed, over-cooked, and over-promoted. No one seems to want to eat it right now. Volumes on the exchanges have been pretty low for some time now, and while I have no problem with some algorithmic trading, I don’t think that a market comprised 70% or more of computers is a great reflection of global economic conditions.

Are We Turning Japanese?

Some recent economic developments and commentary have lead me to reconsider (or maybe just delay) my inflation forecast. The way things are unfolding right now, I’m starting to wonder if this deflationary patch is a little more intractable than many of us think. After all, Japan faced a similar debt and real estate bubble in the 80s. They have been attempting to ignite some form of inflation for decades now – to no avail.

Why have ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) in Japan failed to dispense with deflation? Could we see the same thing in North America? I’m going to meekly say that the answer to the latter may be yes. I only say it meekly because I’m really not sure and I don’t have the financial degrees behind me to say it louder.

But I wonder . . . Maybe a ton of money supply from Ben Bernanke and company just isn’t enough to spark any type of inflation. Maybe what we really lack is money demand. You can flood the financial system with as many dollars, yen, or pounds as you like. But if nobody wants them, they won’t create any growth. Maybe the banks are willing to lend me money. Maybe I can’t afford to borrow it. Maybe I’m already past my debt quota. Maybe what we are really missing is velocity. We need money to move. That’s not happening right now.

We need real, not artificially-induced economic activity. We need people who want to, and can afford to buy goods from suppliers who can in turn build their businesses by providing high quality goods and services. I would love to invest in such an economy. We need leaders with the courage to make cuts where necessary and admit that the gigantic stimulus packages just delayed reality for a while. I would love to vote for such a leader.

But alas . . . I don’t see any businesses like that right now. More disturbing is the leadership/integrity vacuum on the political stage. I’m afraid that zombie banks are here and Japanese disease is headed West.

I apologize in advance for the following video link. You can curse thank Mr. Cents and his regrettable penchant for 80s nostalgia for it. Still, this song, called Turning Japanese, seems sort of apropos in its hollow, popish, soulless repetition. (Apparently the bull market in music ended around the same time the bull market in stocks began.) The band is called The Vapours. I think that speaks for itself.

The economy is out of balance. Our culture is out of balance. Truth and integrity are missing in action. I can’t invest in that.

I just googled the word flation. Apparently I didn’t coin the term. But if you look it up, you’ll probably find some interesting articles on this whole debate. Hey – google wasn’t a verb a few years ago either, so maybe this flation thing will catch on! 😉

Where do you stand on the flation continuum?

Written by Kim Petch

10 Responses to Inflation or Deflation: Which Is It?

  1. Nice post. We might be seeing a bit of both; that is, a decline in real asset prices (houses, stock markets, etc…) as well as a decline in the purchasing power of the dollar. Both can happen at the same time, and it’s a scary proposition.

    • These concepts can be pretty confusing. I don’t pretend to have a great handle on all of this, but no matter how many times I go over it, I come up with the conclusion that extra caution is warranted. The idea of falling asset prices and declining purchasing power isn’t pleasant. We live in very interesting times.

      Thanks for your comment! 🙂

  2. I agree with InvestItWisely, we can have both. In fact part of the problem in differentiating the two is that we already have both. We have deflation in wages, housing and certain manufactured goods, but inflation in healthcare, utilities and other critical services. Then we have energy and food as swing factors that can erupt in either direction with little warning.

    We seem to have persistent real inflation (decline in purchasing power) even as certain prices fall. It may be that anything debt related is deflating into an environmetn of general inflation. This would explain the confusion on which way we’re going.

    Just a guess, but eventually the debt backed side of the economy will play out, then we might enter a time with more obvious inflation, but that’s pure speculation on my part.

    Great post!

    • I think you hit at the core of the problem when you differentiated between the deflationary winds coming from the debt arena and the “real” inflation that’s possible as a result of money supply growth (printing money) to combat the deflation. Very low interest rates have contributed to some of the inflation as well.

      While we worry about higher interest rates as a result of inflation, I wonder if selectively higher rates as a result of credit market problems may be another threat. Witness this morning’s failed ECB sterilization auction. That has U.S. bond yields falling sharply, but those of debt-laden countries like Spain rising. How long before the bond market pays attention to the U.S. debt problem and starts to dump American treasuries as well?

  3. That’s really the central issue–there are too many forces pulling in too many directions. Not only is it difficult to project what might happen, but preparing for it is even more problematic.

    It’s hard to believe that the stock markets have risen as much as they have since early last year given the heavy crosswinds. Collective insanity is the best I can come up with…

    • After the first few months and a couple of hundred S&P points, I thought the rally started to seem unreasonable too. But I’ve learned not to be surprised by any market action over the past couple of years.

  4. I agree with the rant on artificially-induced economic activity. It does get quite aggravating. Everyone knows this type of market manipulation can’t last forever. Perhaps the hope is that such manipulation will not need to last for much longer. The problem is some more pain is likely necessary before the markets heal. If we keep prolonging the pain, we also may prolong the recovery. Hence this is why many believe a slow recovery is more likely than a double dip. Investors hate such uncertainty (i.e. unpredictable manipulation), which is yet another reason why this economic environment sucks.

    • I didn’t realize I had reached rant levels, but on re-reading the conclusion, I think you’re exactly right. I did rant. Watching this all unfold as our leaders continue to ignore those who got it right (and take counsel from those who got us into this mess in the first place) can be pretty frustrating.

      I think you’re right about the fact that some of the manipulations will likely delay the recovery. Only time will tell if we actually experience a double dip. I’d say the chances are better than 50%. If if we don’t slide into another outright recession, we’ll likely have muted growth for some time.

      Investors need to trust the rules of the game if they’re going to put their money on the table.

  5. For the last 5 years, I was convinced all this money printing was leading to massive inflation. Fast forward to now and with the credit crunch deflation seems much more likely. Money is not just the currency that is in circulation, but should also include credit. It doesn’t matter how much helicopter commander Ben prints money if overall credit is declining.

    • I think you’re right. A lot of the money the Fed has made available is not being put to work in the economy. Banks are holding it on reserve, probably to offset the toxic assets that would torpedo their balance sheets if they actually had to mark them to market. We need velocity in order to have real economic growth. Right now, money just isn’t moving.

      Thanks for stopping by and for contributing to the conversation!

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