Tuesday, June 22, 2010

Inflation vs. deflation, revisited

I have written extensively before about the inflation vs. deflation dilemma. There are huge stakes and risks involved for investors. Get the call right and you’ll be a hero; get it wrong and you’ll be the goat.

Why are gold and US Treasuries rallying?
Now more and more people have weighed in on the debate. The Economist/Buttonwood blog recently asked the question "why are both gold and US Treasuries performing so well?" One would suppose that their returns should be polar opposites of each other. The answer is that the inflation and deflation views are increasingly becoming bifurcated among investors [emphasis mine]:

Martin Barnes of Bank Credit Analyst, a research firm, points out that the direction of official policy (low rates, quantitative easing, big deficits) looks inflationary but the economic fundamentals (a big output gap, sluggish credit growth) look deflationary. Faced with this dichotomy, investors who buy both Treasury bonds and gold are not displaying cognitive dissonance. They are just hedging their bets.

Inflation risks from the US printing presses
James Hamilton at Econbrowser believes that the current environment is deflationary, but he is worried about the seemingly inevitability of inflationary policies down the road:

The source of my concern about long-run inflation comes not from the expansion of the Fed's balance sheet, but instead from worries about the ability of the U.S. government to fund its fiscal expenditures and debt-servicing obligations as we get another 5 or 10 years down the current path. Just as many analysts have had trouble seeing how Greece can reasonably be expected over the near term to move to primary surpluses sufficient to meet its growing debt servicing costs, I have similar problems squaring the numbers for the U.S. looking a little farther ahead.

The way that I would envision these pressures translating into inflation would be a flight from the dollar by international lenders, leading to depreciation of the exchange rate, increase in the dollar price of traded goods, and possible sharp challenges for rolling over U.S. Treasury debt. We've of course been seeing the exact opposite of this over the last few months, as worries in Europe and elsewhere have resulted in a flight to the dollar and the perceived safety of U.S. Treasuries. That appreciation of the dollar has been one factor keeping U.S. inflation down. So any inflation scare is clearly not an incipient development, but instead something we'd possibly face farther down the road.

Developments are policy dependent
David Merkel at Aleph Blog wrote about the Social Security time bomb [emphasis added]:

There are no good solutions now. Budgetary cuts and tax increases reduce the possibility of government default. They also will tend to slow the economy, unless the tax increases stem from cutting cheating, and the budget cuts affect only things that are a fraudulent waste.

Once you reach the point of no return, it doesn’t matter what prescriptions one follows — failure is coming. One can shape the type of failure, but not that there will be failure.

All that said, there are still options, though none of them are good. Will the currency be inflated? Will the government default? Will taxes be raised dramatically? I don’t know. Be alert; be ready. The endgame is here; we will see what moves the government makes.
I agree with Merkel. The government seems unwilling to make the hard choices so the collapse is coming. The kind of collapse is entirely dependent on policy…and we have no idea which path the authorities will choose (or humorously, what the consequences are, hat tip to Crossing Wall Street).

Buy-and-hold asset allocation = riding a salt-n-pepper ride at the carny
For investors, Cassandra does Tokyo draws the parallel of the current inflation/deflation situation to being on a "salt-n-peper" ride at the carnival, a musical metronome, the Newtonian pendulum, or the sand-weighted Punching Dummy:
Humanity, in general, their households, and their sovereign and corporate institutions alike will undoubtedly take hits - many hits, and from all sides - but life will go on, and as in post-war Europe, Lebanon, Argentina, Turkey, Serbia, and other seemingly unimaginable examples to our unpracticed imaginations, it will rebound and rise again, in fits, starts, almost randomly lurching to' and fro', before balancing upright again - if only to have the collective shit kicked out of it yet another time...
Under such a volatile environment, preserving financial staying power will be of utmost importance. Fixed buy-and-hold asset allocation solutions will doom an investor to mediocre returns in such conditions. Investors need to go back to basics and rethink their asset allocation assumptions. It's time to stay flexible with the use of dynamic asset allocation techniques such as the Inflation-Deflation Timer model to survive the coming crisis.


Rational National said...

Great analysis, thank you!

McKibbinUSA said...

In my view, monetary contraction (as in austerity) risks deflation and depression. Conversely, monetary expansion (as in "printing money") risk inflation and recession. Given an opportunity to choose between these two risks, I choose monetary expansion and the risk of inflation. More at:


Thank you for the opportunity to comment...

Cam Hui, CFA said...

I agree and would tend to tilt towards the inflationary solution. However, I am willing to be convinced otherwise.

I believe that Inflation-Deflation Timer model is a better way to manage those risks, preserve capital and earn a decent rate of return.