Both Sides of the 'Flation Aisle

Although I think I know how things are going to pan out, I admit I don't have a crystal ball. I also know that there are some pretty smart and experienced individuals out there whose views on the future are somewhat different than mine.

Many believe, for example, that the immediate threat before us is runaway inflation, rather than deflation (which is what I believe comes next). Given events of the recent past (e.g., the Fed throwing caution to the wind), I suppose it is possible that our government could fall in love with Zimbabwean economics at a far faster rate than I expected when I wrote my book.

Regardless, a post at the Prudens Speculari blog, "Observations and Thoughts," provides a helpful overview of where some of these people stand.

I want throw my 2 cents in on the deflation/inflation argument. I am aware of the division on the street regarding this. There are many well traveled shrewd insightful analytical market minds on both sides it can be confusing. I am going to jump around on what many of them think and my thoughts on theirs. It may be a little haphazard, but that is how my mind works. It's ADD combined with hyperness, with a touch of caution as I always assume I am the sucker until I can prove otherwise. (I do so as it tends to save me money!)

Remember I am summarizing what I have read and followed about the mentioned market observers from recent memory. I am NOT quoting them and hopefully not misrepresenting what they think or have said, given that they may have modified or adjusted their positions which is their right. I welcome any feedback or clarification regarding their positions from my readers or even the people mentioned.

• Jim Rogers/inflationist- brilliant, no other way so say it I agree 95% with his outlooks on bullishness for commodities, I diverge with him on China's market, in that I truly believe the corruption and speculation there are endemic and need to be purged out something awful. The economy and the market can diverge significantly. He likes the yen, yuan and the Swiss Franc while hateing the US dollar which I agree with.

• Gary Shilling/deflationist- oozes wisdom no matter what the shallow pollyanas like Jerry Boyer on Kudlow say or think about him. He has forgotten more than lighweights like boyer could ever dream of knowing. Shilling thinks the dollar is done and loves the long bond. I agree with him mostly my exception is with his call on the long bond. I am petrified that foreigners, yeah those cats that buy all our paper are going to realise that we are bailing everyone out and the gig is up. The bonds will tank something awful. People forget that the bond market got obliterated in the deflationary depression of the early 30's. I have not blogged about the bonds in a while but there is not a day that goes by that I don't watch whats going on and contemplate and bond market massacre. I want to short the long bond via the proshares PST(10yr) and TBT(30yr) but have not and will wait on this, call me conflicted.

• Mike Shedlock and Mike Panzner/deflationists- excellent analytical minds with Mish being an analyst at my old firm BMO and Panzner the author of the prescient book Financial Armageddon, which is must reading, especially now that much of what he called is unfolding. Both believe credit is being destroyed faster than it is being created.

• Richard Russell/inflationist- his motto is that governments have 2 choices, inflate or die. I agree but I have to reconcile that with the credit destruction Mike,Mike and Gary are calling. I watch the St. Louis Fed adjusted monetary base chart and it is talking deflation to me. I must remain flexible but the chart is saying deflation unless it is wrong and I am highly skeptical of many government statistics. He is bullish on the equity markets now.

• Bill Fleckenstein/inflationist - He can be summed on with his web site motto, "In a social democracy with a fiat currency, all roads lead to inflation." Very bright analytical mind and a true contrarian. Some dismiss him at first glance but don't let the long hair fool you, wise beyond his appearance.

• Marc Faber/inflationist- believes money creation is full throttle ahead. like emerging economies like South Korea. Dr. Doom is a misnomer as he has been bullish on many markets when need be.

• Jim Sinclair/inflationist- believes the derivative situation is dire and we are heading to a Weimar republic situation. Calling for the $USD at 52 which I cannot disagree with and believe. He is looking for $1150 and then $1600 gold. I lifted the following from his web site Jim Sinclairs MineSet",There is no escape from a Global Weimar Experience as Central Banks monetize bankruptcy. Equity markets in the Weimar experience went to unimaginable levels on the upside." Given my disposition to being short this sits in the back of the mind on a constant basis and not in a good way.

This is a short list I may do another one with more shrewd cats I try to follow. So where does this leave us here at Prudens Speculari.

I believe we are experiencing unprecedented credit destruction and contraction and the banks retrench. Economically I am an Austrian at heart and inflation is everywhere and always a monetary phenomenon. I believe credit increases are inflationary not a rising oil or corn or what have you price, which is a reflection or symptom of the credit increase. I am watching the adjusted monetary base chart for clues.

To be blunt I am watching for things that the correlation, black box, intellectual thinkers believe cannot happen. Government remedies and intervention only exacerbate the issues. I am worried that things are so critical and so dysfunctional, and that as market participants try to adjust and feel their way around we can, are and will get temporary misleading signals as 'the market digests what is truly going on. Which I feel is a bursting of the mother of all bubbles, the credit bubble, whose ramifications are global, UK, continental Europe, and Australia. Its attendant effects on banks, credit creation and the consumer.

I sit sometimes thinking globally we are on the verge of a Daimler/Chrysler situation. Remember that, it was called a merger of equals but I remember an obscure analyst whose name I cannot recall who claimed that either Daimler came down to Chrysler's level or Chrysler came up to Daimlers'. As my wife is fond of saying, water finds its own level. Globally are we going to find the emerging markets economic level or are they rising to meet us. I think it is a combination of the 2 with them coming to us, slowly but surely but more problematically we falling faster to them.

Should we be long emerging markets short developed UK, US on a spread trade. Not a bad idea. I don't believe we can decouple. We consume like nothing else can and those hoping the Middle East and BRIC countries will replace us lockstep is fantasy. Our economy is 70+ % the consumer and it took us decades to get where we are, Should I believe they (BRIC) consumer will arrive at the same place overnight.

I am a peak oil believer. We are not in a bubble although speculation is present everywhere and always. Simply put easily accessible and plentiful suppy has all been found. Demand is rising, recession or no recesssion. Crude is still cheap compared to other goods. Gold is insurance but may very well become money, for as an Asia college buddies grandfather used to always say, "no trust paper!"

So where am I ? I am squarely in the deflationary camp, with the perogative to change my mind at any time !!!

My apologies for the lengthy post but I do this for me as well as my readers, buy mainly so I can go back and read over how stupid or wrong I was at any particular time in the past !

Wishing you continued success in all your endeavours and above all Good Speculating to you all !

Comments

[Aaron Krowne]

I read and collaborate pretty extensively with people on both the "inflationist" and "deflationist" side. In a funny way, I think they are all right, and all wrong. And they all disagree vehemently, but actually are in agreement.

I think there are two points that most commentators ignore or neglect:

1) The financial dynamics are now international; you cannot just endogenously analyze one country, such as is the case with nearly every macroeconomics textbook everyone has read. While the dollar had indeed become the "de facto global reserve currency", allowing this point to be ignored for many years, that situation is now quite clearly coming to an end.

One implication of this point is that the base money quantity in a single country may not matter much -- when, like the US, that country relies heavily on imports and loans from abroad (especially FCBs), it becomes subject to the whims of the rest of the world. In this case, inflation, and quite likely a series of "de facto interest rate hikes" by striking foreign lenders.

2) A lot of money and credit have been created over the last three decades, even though CPI-inflation has been pretty benign since Volcker. Why? Probably because neo-liberalism and finance-centric economies have allowed most of the money and credit creation (inflation of the Austrian variety) to be siphoned into asset markets, as opposed to consumer goods. Global wage and currency abitrage are also likely factors, though both are threatened now by the changing financial status of nations.

Anyway, all that excess money and credit created can only come to two ends ... either be destroyed as someone's write-off, or move around. The natural tendency is to do everything possible to simply move the money and credit around, not destroy it!!!! This is achieved through both public and private means.

The upshot is: a great portion of the money and credit ALREADY CREATED for the past thirty years are now spilling out into various safe havens. Most prominently one of these safe havens is hard assets, and the negative real interest rates of western central banks makes this an "obvious" play. It does not necessarily follow that we need "new money printing" in order to have horrible CPI inflation for the forseeable future; all that historical money creation is now fuel for goods and commodities inflation.

Those are my two points of which I've seen light treatment if any from analysts. If you consider them it is hard to fall into either the "inflationist" or "deflationist" camps. Financial deflation is quite compatible with CPI inflation; yet that CPI inflation does not require abandoning the Austrian definition of inflation as money/credit creation, because the money/credit is already created.

A quick aside, Krugman actually wrote a pretty good column today about the oil non-bubble:

http://implode-explode.com/viewnews/2008-05-12_TheOilNonbubble.html

[Shankar Khadye]

Michael:

Although I am in a deflationary camp, I came across the following article. I was wondering if we may see hyperinflation as opposed to deflation.

http://www.shadowstats.com/article/292

However, I also saw the iTulip article on why hyperinflation is not possible.

http://www.itulip.com/forums/showthread.php?p=35614#post35614

My personal thinking is that we are seeing inflationary recession, which will get worse (much higher inflation) before we dip into deflationary recession/depression.

Your thoughts on possibility of seeing hyperinflation?

- Shankar

[Independent Accountant]

Mike P:
I check your blog about twice a day and agree with the majority of what you write. I too am an Austrian, having read 17 of von Mises books alone. That said, I am a Marc Faber guy, agreeing with 95% of what he writes. I expect higher inflation over the next decade, possibly averaging 10-15% with measured CPI inflation at 4-6%. If the Fed loses control of the situation we may see inlfationary "spikes" of 20-30% for a year.
I wouldn't own US dollar denominated bonds with a maturity over five years if you bought them for me with your money. This leads a surprise conclusion: I am a stock market bull in all sectors except FIRE: finance, insurance and real estate. The real bear market will be in long-term bonds. Look out below! Oh yes, and have a nice day.

[Shankar Khadye]

Independent Accountant:

I have a hard time seeing inflation spikes of 20%+ and collapse in long-bonds associated with bull market in stocks (except FIRE).

Higher inflation and higher long-term rates will probably rob population of the purchasing capacity. Profits of companies will decrease dramatically due to higher input costs.

If what you suggest turns out to be the case, then the right asset class might be commodities.

- Shankar

[Al]

I see inflation and deflation happening simultaneously in different asset types.

If you need it (energy, food) it's inflating. If you don't (electronics, luxury items) it will deflate. Housing initially seems not to fit with this (it's a need but deflating) but it depends how you look at it. Owning a house is a luxury (thus deflation in housing prices) while renting is a necessity. As such I predict rents will go up.

Credit destruction will cause the deflation in non-essentials while scarcity and flight to quality are driving inflation in necessities.

My analysis may seem simple, but I find simple works well most of the time.

[Waiting for the Other Shoe to Drop]

I agree with AL, but would like to add the following:

Government spending (debt) is holding what is left of the US economy together. Unemployment seems to be accelerating but employment still seems to be substantial. If that changes (gov spending and employment), we will see deflation on a massive scale. All through the biggest debt bubble/tax revenues in history, Gov's (Fed, State, & local) all went further into debt (more bankrupt). Here in California they are talking about a $20 billion dollar defict next year( about 17% of the total budget). Sooner or later this will mean reduced Gov spending (this can happen with inflation too... same $ buys less) and mass lay offs for both public and private sectors.

Either the US, State or Local Gov's credit ratings go to near ZERO (because of exsisive barrowing)and can't get aduquate spending money or they reduce spending themselves, sooner or later it's DEFLATION !!!

[Robert J]

Shankar-
You are correct, sir! Some items going up, others going down. I guess this would be the norm, as everything fluctuates, but things really seem to be going dramatically faster, up and down, or at least poised to go up or down quickly soon.

Question to all the prognosticaters out there:
I am about to close on my house in Utah, a state that has done well, only lost a little value recently.
How long would you wait to buy? We're hoping to cash in our equity on a new home in 5 months. Would you wait longer? If so, why?

[Waiting for the Other Shoe to Drop]

Mr. Shankar why would you buy a house in the worst housing market since the 1930's (or soon to be)? We are only in the 2nd or 3rd inning of this debacle.
Bottom line you must run the numbers. Is it cheaper to rent? My guess is that it is. Weigh that against the risk of owning. What if you have to move? Keep monitoring the housing market where you want to buy. Maybe by 2010 it will be less risky. You might be surprised at what you can find by renting.

Good Luck.

[Shankar Khadye]

Waiting for the Other Shoe to Drop:

I am not buying a house. Robert J (comment above yours) is purchasing a house.

Personally, I don't think housing market will bottom out till 2011 or just thereafter. And it may stay stagnant like that for another 8-10 years after that. There was a fantastic article written by Jim Grant, Interest Rate Observer on this issue.

- Shankar

[Robert J]

Thanks for the feedback, I appreciate it!

Clarification: I'm about to close on selling my home.
I have the benefit of sitting back and seeing what happens, and also of working with a friend that specializes in pre-foreclosure homes that should take a good 30% off retail for me judging from past deals.

So, I can bide my time if I want. By plugging our equity into the new home, my payment should be about $500, $650 after taxes and insurance. Definitely cheaper than renting for now- the main question is, cheaper than renting or buying in another year?

The ideal would be to hold on until my original equity check I'll get next week translates into the majority of the next home's price (we have about $90K or so in equity we'll be able to put down)

[Shankar Khadye]

Robert:

I have a hard time seeing house prices going up in the next year. Another set of rate resets will occur starting June-July. Add to that huge losses still to be taken by the banks and ongoing (and worsening) credit deflation and you have a recipe for continuing housing meltdown.

In our area, rents for houses are approximately same as the rents for the apartments (same number of bedrooms). So we are actually considering renting a house as opposed to buying one. I don't expect to buy a house till late 2009-2010 at the earliest.

Shankar

[roger]

inflation/deflation=a very contradictory hard to understand concept for my simple brain.for me the bottom line is how many hours of labor are involved in the purchase of a basket of groceries,ho I forgot I'm retired grow my own veggies

[just dug]

Despite expecting a repeat of the 70's stagflation on a larger stage for years I now think over the shorter term a mild deflation is the most likely result since interest rate cuts don't solve solvency problems and the pool of real savings from which to generate a recovery, while overcoming the headwinds of gov't meddling, has been drained after years of unrelenting credit expansion. But longer term Bernanke et al have made it very clear that deflation is a fate worse than death and will be fought by any means necessary, and unfortunately the only response their views permit is attempting to print prosperity.

[Waiting for the Other Shoe to Drop]

Robert J

Your forgetting the once virtuous lifestyle of being OUT OF DEBT !!

Take your $90k pay off all your bills, rent some nice place close to work (save gas $) that is affordable, take the rest and have a nest egg. Prepare for the worst social and economical chaos since the 1930's !!!

I sold my house in 2004. And first time in my adult life I am out of debt !! It's a great feeling.

Best of Luck