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