Inflation vs. Deflation

So, a few things have changed since I originally wrote this article, but for the most part, it still holds true. The real change has come in that the Fed has given some more details on how it will be able to combat inflation using a different method, should the need arise before they can sell some of the assets off their books.

There is a significant debate right now among analysts and economists as to whether or not the U.S. is still headed for a deflationary environment or an inflationary one. This newsletter is meant to help explain the two sides of the argument, where I think we might be headed, and what that might mean for your portfolio strategy over the next 5 years.

The thing to keep in mind is that the whole debate revolves around the supply and demand concept. Supply usually only changes to follow the demand trend. Demand is really generated by how much money is flowing through the system. It is part of the Feds job to keep us out of deflation and high inflation by keeping “enough” money in the system to instill the “proper” level of demand. Deflation occurs when there is a period of contracting demand thereby driving prices down. Inflation occurs when demand is higher than supply, bringing prices up. The way the Fed controls this system is by either taking money out of the system (by selling assets that it has bought up and deleting their profit) or by putting money into the system (by buying assets with previously non-existent money). During a negative economic growth period adding more money to the system is like dripping water onto a sponge. It will take a significant amount of water before the sponge can’t soak up any more and water is spilled out.

That is where the debate comes in. Some believe that the sponge, despite the massive amounts of money the Fed has pushed into the system (most estimate the amount of money to be in the trillions), is still drying out due to the evaporation caused by this crisis. Others feel that, while water hasn’t come out yet, we are pouring so much in that by the time we stop too much will have gone in and we’ll flood – high inflation will return.

Since there is no way of knowing if or when inflation will come back because no one is quite sure how much money the system lost (or soaked up), the Fed apparently intends to err on the side of caution by pumping in money until they see a little coming out of the sponge. They are targeting an inflation rate of between 1.7% and 2%. Source: http: //www.federalreserve. gov/newsevents/press/monetary/20090218a.htm.

My concern is how quickly the Fed can sell the assets on its balance sheets in order to strive for the targeted range. While no one is quite clear on what assets are on the Feds balance sheet we do know that they have purchased a significant amount of mortgaged backed securities and debt issued by Fannie and Freddie. Since these assets are normally liquid, that isn’t the concern. My concern is two-fold: Given the current political environment (selling massive amounts of mortgage securities may raise mortgage rates sharply) can the Fed clear its book of these assets? If the Fed needs to sell these assets soon, who would be willing to buy mortgage backed securities and Fannie/Freddie debt?

At the very minimum I believe the Fed may get its wish of 1.7% to 2% inflation. At the recent National Association of Business Economics Policy meeting the consensus was to expect around 2.5% inflation over the next 5 years. So what does this mean for investment strategy?
Though past performance is no guarantee of future results, historically equities, commodities, and TIPS have performed well in inflationary environments. Of course TIPS may not be right for your portfolio, and not all equities and commodities are good ideas at this time. In fact, some models (source: www.riverfrontig.com) show that gold may be overvalued by 60%, but for some short-term investors, it might be a good tactical investment.

With equities, many highly valuable companies are on sale and now, following the fundamental idea of buying low and selling high, might be a good time to buy depending on your overall investment objectives and goals.

Some other good news has arrived and I have heard from many the question: “So did we hit bottom? Are we finally coming out of this?”

I don’t think anyone knows for sure, however, I think Bob Doll of Blackrock puts it best when he says: “On balance, we do believe that the recession has peaked and that the economy will stabilize in the second half of this year. Achieving such stability will remain a challenge for policymakers, and the environment remains fraught with risks. In any case, our confidence is growing that global equity markets are ending the bottoming process that started with the waterfall decline last October and that the lows from early march do represent the lows for this cycle. Should that be the case, we would expect the United States to continue to outperform other developed markets and believe that emerging markets and commodity-related investments should also continue to outperform.”

To sum it up, I’m cautiously optimistic

Great Quote to Think About

For all of the bloggers, including myself, out there, this is a great quote to keep in mind (I read this quote in the letter to shareholders written by Jamie Dimon, President of JP Morgan, one of the few strong financial companies left because of how they did business):

“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of the deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.” - Theodore Roosevelt

Regardless of where I disagree with our government and where I think they could have done better; I am proud to see that they acted. Upon getting more and more bad news (often times worse than the news from the day before) every single day they acted to help solve the problem and perhaps get ahead of it. Hind sight is 20-20 and mistakes were made, but I don't think anyone can say that our Government didn't try the best solution they had on hand at that time.

On a different point, to go along with the above post, I am going to try with this blog to look at each issue from all perspectives by putting myself in the shoes of those making decisions and acting, to see what I might have thought or done had I been the one in position. I am also going to be doing more myself. I write my representatives, I complain and whine to those who'll listen, but I don't stand up and do something about those things I believe strongly in. I hope to post soon about how I have changed that.

The Problem with Government Loans

So this is just conjecture at this point, but it will be interesting to see if anyone has already seen studies on it, or when there will be studies on it, whether or not they show I'm right.

I was reading the news today and noticed that data is showing that all types of consumer loans are increasing in defaults. I was thinking about that in comparison with the unemployment rate and then remembered that retail sales have been increasing since the start of this year. People are beginning to buy things again.

Part of those sales are coming because people are finally back in the stores buying necessities that they have been going without. Part of the buying is because people have been saving more and more since October of last year (mostly the wealthy, who, coincidentally have actually seen pay increases over the last year). Those who were saving their money were really hoarding it until things seemed to have bottomed out, so until today, I thought that the retail sales were due solely to this spending. Now I have a different thought as to why some of that spending is there.

Our government seems to be coming out with a multi-billion dollar program every week that is designed to give free money (grants in most cases not loans) to people who have been struggling or will be struggling over the next year. Most have just been outraged about the struggling home owner help, but there has been quite a bit more than that going on.

So here's my theory: Those who have been struggling to make their payments, but have been making them by foregoing a lot of normal everyda purchases, are now going out and buying those things and defaulting on their payments because they know they will get bailed out on at least partially on one of those payments.

I think this might be the case because you have to be defaulting on payments in order to get aid, and until now many have just been struggling through barely getting enough to exist while still making their payments. I have to admit, with the way the government is spinning this ("it's the big bad bankers fault not yours, just take this money and we'll make it all better.") it certainly does have a small appeal to just stop making my mortgage payment for a few months, or stop making my car payment so that I can get some "free" government money.

Of course the catch with doing that is a destruction of personal integrity along with credit score. Short term gain with a long-term problem. Why is it that our government seems to be going to extremes to give us this short-term gain while building up the greater likelihood of major problems in the future?