Inflation vs. Deflation

In a continuous effort to try and understand what the world will look like in the next several months (and therefore our investments as well), the dynamic between inflation and deflation should be understood on at least a basic level.

 

First, let's understand what both of these really are.

 

Inflation – too much money chasing too few goods/services.  So if there’s lots of money in the economy and the individuals who have it are buying stuff (there’s that technical term again), there will be higher competition for the stuff, which results in higher prices.

Deflation – too much debt and difficulty making the interest payments.  Need to sell stuff to reduce debt exposure.

With the issues in Europe and even here in the US regarding the need to reduce debt, it appears to me deflation is in control, which would mean lower prices for stuff (stocks).

I would offer the more interesting question is how will we know when the economy switches from a deflationary stance to an inflationary stance as this will have a significant impact on the prices of food, gas, and other consumable items.  During a high inflationary period, you will see the prices you pay for goods and services go up and potentially faster than you see the value of your paycheck increase each year.

Inflation is made up of two parts.  The first is an increasing money supply.  This is how many dollars are in the economy.  The second is how fast each of theses dollars are turned over (or said a bit different, once someone spends a dollar, how quickly does the person receiving the dollar turn around and spend that same dollar).

Let’s look at a chart showing how many dollars are in the economy and see if it has been increasing:

Looks to me like we definitely have an increasing money supply.  It even looks as though it’s been increasing at a higher rate since 2000 (have to print money to fund these bailouts).

Next, let’s look at the velocity these dollars to see quickly they’re changing hands:

Looks to me as though anytime someone gets their hands on some money, they’re not doing anything with it.  Since we need both for inflation, as long as the velocity points down, deflation will be in control.

So, once velocity turns up (people start spending all of this money, which they will at some point), we will begin to see inflationary pressures.  The outcome of this will be the Federal Reserve raising interest rates (think in terms of the interest you can get for a mortgage, if you have a variable rate you will start to see your monthly payment rise as your rate adjusts) to slow down the pace of inflation by selling securities to collect some of the dollars you see in the first chart.  The simple way this works is the Federal Reserve sells securities and when someone buys these, it takes this money out of the system.  Also by “flooding” the market with securities, it will drive the prices down, which has an increasing affect on interest rates (ex. you own a bond, which you paid $1000 for and it pays $50/year, if someone paid you only $500 for this bond because there are a lot more of them in the market, they would still collect the $50 and so their interest rate received would be higher than what you were receiving; or $50/$1000 equals 5% whereas $50/$500 equals 10%).  If you recall from a previous post, interest rates are at historical lows with nowhere to ultimately go, but up.

Over the next several months, look for deflation to persist as countries and banks look to unload assets to clean up their finances.  Then watch the velocity of money for a signal when times may be changing.

I still get an eerie feeling the stock market is teetering on the edge of a cliff.  The euro has be accelerating its move lower, which I can’t help but think this means we will soon be hearing some negative news come from our friends across the pond.

Cheers,

Joel Fink
joel.fink@yahoo.com