The Tally Stick

Taking measure in our times

Deinflation – A new theory for our current economic reality

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If you are following the financial media, you keep hearing a recurring debate & theme of “Inflation vs. Deflation“.  In the inflation camp, it cites ballooning federal deficits, quantitative easing (read: print money), debt monetization numerous stimulus programs and large corporate bailouts.  In this scenario, this massive amount of money and credit expansion creates price inflation across all asset classes, effecting imported goods severely.  With interest rates at all time lows and the expectations for inflation rising, people with dollars will be in effect “forced” to speculate by investing in different assets to get a real rate of return that equals the expected inflation rate because the normal safe investments are paying so little with this low interest rate environment.

In the deflation camp, you have a massive destruction of credit in financial system starting with the sub-prime meltdown, bleeding into the credit-default swaps (CDS), commercial mortgage backed securities (CMBS).  This combined to decreased the wealth of households, pensions and foundations by trillions of dollars.  This reduction of wealth creates a massive gap of money that is needed to support asset prices at the same level before the crisis started in March of 2007.  With this gap, prices are pulled down because the money & liquidity are not there to support the interest payments on the debt that is attached to all these asset classes.  Along with high unemployment and stagnating incomes, it draws the economy and corporate earnings in a “reverse multiplier effect” down until it finds a balance that can support prices.

Theory of Deinflation:

I propose that both camps are correct in their own right and we will see elements of “both” camps happen during the same period.  This is my “Theory of Deinflation“.

Asset prices in areas that are not seen as an “inflation hedge” will see deflation, in 2009 that would be considered fixed assets that rely on transactions to determine their value and price.  As this happens, people with their wealth tied to these assets will have less disposable income available to purchase goods so you will see reduced demand and in cases where there is not enough income, you will see defaults and foreclosures and that will pull down prices on more of the same asset classes. This is the “deflation” piece of this theory.

The inflation piece comes with the artificially low interest rate environment and rising inflation expectations.  As the public believes we are going too see inflation from all the increased credit and stimulus.  At the same time, the rate of return of traditional “investment grade” investments are lower that the real or expected rate of inflation so it forces people with savings or fixed obligations to go into the market and speculate so bring their rate of return to their previous level before this process started.  When they are looking for assets to purchase, they go after assets that are regarded of “inflation hedges” which includes commodities and energy.  As these purchases increase you see the prices in these assets trickle through the system until it ends up at the retails level and that raises the inflation expectations and feeds into this positive feedback loop.  This is how we accomplish deflation and inflation at the same time, hence the name “Deinflation”.

Please leave your comments or anything you would like to add for my review.

Written by Tally Stick

September 25th, 2009 at 12:10 pm

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