February 26, 2010

Inflation Versus Deflation, The Ongoing Debate

The heated debate over inflation/deflation continues. Depending on time frame and data points, the pendulum appears to be swinging back and forth between the two opposing camps which stand firm and passionately support their views.

The supporters of inflation point to the massive stimulus efforts by the Fed and other central banks which lowered interest rates to historically unseen levels and they used an array of easy money measures including quantitative easing to spur economic activity and growth. Such easy money policies should, in theory, lead to inflation somewhere down the road, so their argument.

The deflationist camp however argues that further deleveraging is necessary. Stubbornly high unemployment would lead to a demand crunch and a longer than expected housing slump would make any return to higher price levels unlikely. Some evidence of that was presented in the recent core CPI data showing the first, albeit miniscule, -0.1% drop since 1982. Mr. Bernanke, in his recent remarks before Congress, re-emphasized that extremely low interest rates would remain for an extended period of time given a potential slow-down of economic recovery later this year.

Let me try to put both camps in some disarray...

In terms of the inflationist view, one has to concede that ultra-low interest rates and easy money are typical text-book moves in spurring economic activity and the typically unavoidable inflation that comes with it. This time might be different however. Money and credit given to the banks has not found its way into the economy because it made more sense (and still does) for banks to park that cash taking advantage of the instant money making give-away i.e. borrowing at near 0% and buying Treasuries – easy returns for the banks at no risk. Given these hand-outs, why bother with much riskier consumer or commercial loans, particularly given the chance of further declines in asset prices. Looking at it from the supply side, so what if interest rates are at historic lows? On paper, one might get a 30 year fixed mortgage for 5% but banks aren’t lending, so strike that argument. From the demand perspective, businesses and consumers are scared and they would much rather reduce their leverage and save in view of a difficult economic recovery or worse, a possible a double-dip recession.

To the deflationists, I would point towards the increasing cost of healthcare, education and other necessities that put the prospects of lower prices into question. For instance, California health insurance giant Anthem Blue Cross scheduled rate hikes of up to 39% as reported by the LA Times. If you have children in schools or college, you know for a fact that there is no deflation whatsoever to be found in the cost of education. For many other countries unthinkable, US students can easily pay $40,000-$50,000 per year for the cost of a college education. In terms of deflationary trends in financing, have you read the fine print on your credit card agreements recently? Financing rates of 20% or higher are not exactly indicative of deflationary trends. Other price indicators like oil don’t appear to be heading back to below $40 a barrel prices anytime soon either.

The true inflation is probably best examined in terms of the “felt-inflation” which is of course a lot harder to measure because it’s different for everyone. One has to look at various scenarios and a possible scenario for a US person might look like this:

You have a secure (government) job, full benefits (i.e. benign healthcare costs), recently bought a house taking advantage of the low interest rates and the depressed housing prices, and you live in a nice neighborhood with a public school district still intact, then yes; recent and possibly near-to-medium-term outlook would indeed be deflationary.

However, if your income has been stagnant for the past 5 years (that is if you are lucky to still have a job), you bought your house 5 years ago with an adjustable rate mortgage, you do not have an employer sponsored healthcare plan and you send your children to a private school while paying for some essentials with credit cards, then deflation must feel as an unreachable as Nirvana.

Defining and measuring inflation is one thing. One could argue whether the baskets of goods measuring consumer and producer prices are adequate and whether one can trust the data and metrics. However, a more realistic measure, albeit more difficult to implement, would be a scenario based personal inflation barometer similar to the Cost of Living Index and using that as a determining factor for policy and investment decisions.

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