Deflation, Then Inflation
One of the most vexing questions plaguing investors these days is whether or not we’re headed for price deflation or price inflation. There are two offsetting influences…that will undoubtedly determine the direction of price growth.
History has shown that credit contraction is one of the harshest sources of deflation. The most recent Federal Reserve survey of senior credit officers showed that nearly 70% of surveyed banks have tightened their mortgage-lending standards. Stinginess among lending institutions is largely responsible for the 16% decline in our nation’s $22 trillion housing stock. Margin lending has been cut in half, forcing leveraged investors, like hedge funds, to disgorge marketable assets. The pullback in housing and equities, combined with plunging commodity prices, helped push consumer prices lower recently. Yet without the impact of food and energy, prices were essentially flat.
Persistent deflation is bad for the economy. Faced with declining sales and fixed interest obligations, companies will find it increasingly difficult to stay current on their debts. Consumers, facing similar challenges, will defer spending. Deflation fears have prompted lenders to require yields approaching 17% when purchasing below investment grade bonds. Offsetting the downward pricing spiral is unprecedented monetary and fiscal intervention in the form of stimulus and bailout programs.
The Fed’s balance sheet has expanded by $1.3 trillion in the past year. The Treasury has backed banks and money-market funds, has taken in the government sponsored mortgage companies and is toying with…bailing out the big auto makers. Eventually, this monetary expansion will push prices higher. Meanwhile, the Treasury market suggests prices will decline before they expand. The break-even inflation rate between inflation-protected Treasury notes and fixed-rate Treasury notes is nearly minus – 0.5% for the next five years. We recommend that investors brace for transitory deflation this year that will give way to inflation in 2010 and beyond. Take positions now to benefit from inflation and a dropping dollar.