Friday, May 06, 2011

Inflation, Deflation, and Speculation

The most critical economic uncertainty over the next five to ten years is whether there will be hyper inflation, a deflationary spiral, or something in-between. Hyper inflation generally results from a government that creates ever-increasing amounts of currency, which causes the prices of all things to rise and the value of a fixed amount of money to correspondingly decline. A deflationary spiral has the opposite cause and effect; a shrinking supply of money causes prices to decline and the value of money to increase. In our economy a great deal of virtual money is dependent on regular payments to bond holders and mortgage lenders; when these payments are interrupted, retirement accounts are decimated by collapsing bond prices, and banks go bankrupt - money literally vanishes.

The centerpiece of the inflation/deflation question is the Federal Reserve Bank and its chairman Ben Bernanke. If the Fed continues to buy a trillion dollars worth of Treasury bills every year (i.e., printing money) then hyper-inflation is a very real possibility. On the other hand, if the Fed stops the "quantitative easing" programs altogether, then deflation is a risk as the federal government would have to choose between defaulting on Treasury bills (debt payments) or defaulting on promised payments to Social Security, Medicare, Medicaid, etc.

Congress has the power to affect the outcome on its own terms if it wishes, particularly in the timing of changes in the value of the dollar. In the unlikely event that Congress ever slashes the federal budget by 30% or more, the inflationary effect of spending government-sanctioned counterfeit money will vanish, and a deflationary spiral could begin almost immediately. Since Congress doesn't need to issue bonds when the budget is balanced, the Fed's power to create more money would be limited. However, if Congress continues down the path of ever-greater spending and ever-greater debt, then the inflation/deflation ball will be fully in the court of potential bond buyers, including the Federal Reserve Bank.

Individual investors like us can't predict what the Fed or Congress will do this year, next year, or five years from now, so there's no guaranteed way to protect our wealth. I've stashed away actual cash as insurance against a deflationary spiral, but many other investors have instead been betting on high inflation, as evidenced by recent rises in the prices of metals like gold and silver; these buyers are looking for something that will still have bartering value if the dollar collapses.

The price increases in gold and silver are mostly speculative right now because the actual rate of inflation has been remarkably low despite the recent printing spree by the Fed. Indeed, the core inflation rate in the U.S. is barely higher than 1% right now, and hasn't been over 2% since 2008. (Recent reports on the decline of the dollar are referencing the exchange rate between the dollar and other currencies like the euro and yen, rather than the actual domestic buying power.)Meanwhile the price of gold has doubled and the price of silver has more than quadrupled in the same time span. Anyone who bought gold and silver in 2008 now has the opportunity to cash out and make a tidy profit, regardless of the inflation/deflation question. Being a buyer today is rather risky though, particularly if we succumb to deflation instead of inflation. The recent 30% drop in the price of silver may be due to precisely these realizations by investors.

Interestingly, this correction appears to be returning silver to the long-term price trend that it used to share with gold up until 2008.

Given the tame inflation rate so far, the present lack of printing by the Fed, and the potential bubble in metal prices, I'm not going to make a bet on high inflation at this point. Conditions could change quickly due to political shifts in Congress and actions by the Fed chairman, so it pays to keep a finger to the wind.


John said...

This blog is excellent. I have been doing the same "scenario analysis" regarding inflation vs deflation. It is interesting that any inflation we have seen is in commodities (due to a devaluation of the dollar, not demand). We have seen no wage inflation. In fact I would argue that we have seen wage deflation over the past few years. However, as they say, "don't bet against the Fed". It will be interesting to see how this plays out. Could there be continued inflation or maybe hyperinflation in commodity prices due to the Fed creating money and buying Treasuries and at the same time see continued wage deflation. That combo should eventually drive demand down until something gives. Has this ever happened before in any economy?

Jody Wilson said...

I disagree that commodities prices aren't being affected by supply and demand. Precious metals, as I discussed above, are rising due to speculation (higher demand). Oil prices rise and fall with war and peace in the Middle East (variable supply). Agricultural prices spiked in 2008 when we had the brilliant idea to burn food instead of eat it (corn ethanol = increased demand for corn = less acreage for other crops = lower supply).

Keith Wilson said...

This is an incredible post!
Excellent job, very clear and educational

The Western Chauvinist said...

I'm a skeptic on all the government numbers. Unemployment 9%? Riiight. As long as you don't count the people who stopped looking for work.

Same with inflation. I just don't believe it is as low as they say. As my family's shopper, trust me - it's shockingly high.

Producers having been fudging by reducing the package sizes and maintaining the price. For example, I just replenished our syrup supply yesterday at SAM's and the two-pack jugs went from gallon size to half-gallon, while the price is about the same. I count that as 100% inflation.

I've read somewhere recently that if you look at products singly rather than in aggregate, inflation ranges from 10% to mid to upper 40%. This is on the essentials, not the luxuries.

This, while the administration does everything in its power to inflate fuel prices. We are so screwed.

Jody Wilson said...

Corn has tripled in price since the government mandated that we burn it for fuel, and I suspect that this price increase has propagated across the grocery store (corn feed for animals & more demand for corn substitutes) but I don't think that's the same phenomenon as inflation driven by in increase in the money supply.