Tuesday, August 10, 2010

The Inflation-Deflation debate continues

As we wait for the FOMC statement, I see that the inflation-deflation debate is continuing. On the deflation side of the debate, the economy remains anemic and Nobel Laureate Joseph Stiglitz is calling for more stimulus. Moreover, Pimco head El Erian warned of deflationary risks in the US economy.

On the other hand, we have the wheat crisis in Russia, which has pushed up food prices and is raising the specter of commodity inflation.

A volatile decade
Which camp is right and what can investors do?

My answer to the first question is “I’m not sure.” However, I do agree with Simon Johnson, who stated that:

The major risk faced by the world economy is not stagnation year-in and year-out, but rather an unstable credit cycle that produces apparent “growth” – perhaps even high recorded growth – in some years for the United States, but then leads to financial crisis, repeated recession, and very little by way of sustained growth. US GDP in real terms is currently at about the same level now as it was in 2006. (Real GDP, annualized, was around $12.9 trillion in the first quarter of 2006 and $13.2 trillion in the second quarter of 2010; see Table 3B in the July 2010 BEA report).[3]
For buy and hold investors, this may mean a decade of low but volatile returns, which is a possibility that I wrote about before here. However, Johnson offers a ray of hope:

Japan’s lost decade in the 1990s was not a sequence of years with zero growth – there were notable expansions and contractions, with high rates of growth in particular quarters and even some years when it seemed that the corner had been turned. Lost decades are evident only in retrospect. The US is currently on track for “losing” at least half a decade of growth (from the beginning of 2006 through the end of 2010).
In other words, there would be significant cyclical ups-and-downs under such a scenario and it would be possible to trade the swings using trend following models such as my Inflation-Deflation Timer model.

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