Inflation or deflation - which will it be?
Dominic Frisby Aug 27, 2008
Central banks are working to drive up inflation
Inflation or deflation? Which are we going to see?
This is an argument that has come to the surface once again. And it seems to raise just about everybody’s hackles.
I’ve just put together a radio show on the subject (commoditywatchradio.com) with James Turk of Goldmoney, who sees inflation, Mish Shedlock of Global Economic Analysis, who sees deflation, and Mike Hampton of Global Edge Investors, who sees both. I have to say, it’s changed my point of view. I’m starting to see things in a much more deflationary light.
Before discussing what lies in store though, let’s address what exactly people mean by inflation or deflation - because the words are as misunderstood as the subject matter…
What RPI and CPI really measure
The RPI (Retail Prices Index) and CPI (Consumer Price Index) are both ‘measures of inflation’ we are told. But in reality, they are both measures of prices. And that is what many understand inflation and deflation to mean – rising or falling prices.
So, under this definition of inflation, are we going to see rising prices or falling prices? Of course, it depends on the asset class – and in what currency you are measuring. Thanks to the competence of our leaders in government, banking and business, sterling is now falling against just about every currency except the Zimbabwean dollar. The direct consequence of this is that most imported goods are becoming more expensive. Indeed CPI is at multi-year highs.
But CPI is a lagging indicator – the oil price will tell you where CPI is headed and for now oil is in a period of consolidation. (I do not expect new highs in oil in the coming months, but an extended period of consolidation. I would expect $100 to be retested at least once, and it may even be broken, before the bull market resumes its rise). As a consequence of lower oil we will see lower CPI.
Looking out at the world from my desk in South West London, here’s what I see: a Japanese computer screen, an American computer, an American mobile phone, German headphones, a German TV screen, a Korean DVD player, a French bottle of water, Swedish furniture, African fruit, and – at last - English books. Although the paper was probably imported.
You get the point. We import a lot more than we produce. While the downtrend in sterling continues, most imported goods are getting more expensive. Even those mass-produced goods which are falling in price are not falling by as much measured in sterling as they are in, say, Swiss francs.
However, the building in which I am sitting was most definitely made in England, though the most recent facelift was performed by Poles. That building, like our stock market, is falling in value – by quite a lot if you measure it in sterling, and by even more if you measure it in stronger foreign currency or gold.
That is the current price action: falling prices in assets associated with debt - houses and financial stocks – and rising prices in things which you buy with cash – food , energy and some imported goods. But, as I said, CPI may have come close to peaking for now.
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What inflation really means – changes in the money supply
That takes us to inflation definition number two: inflation is a growth in the supply of money and credit, leading to higher prices; deflation is a decline in the supply of money and credit, leading to lower prices.
The last 20 years have seen an unprecedented growth in the supply of credit. Borrowed money has pushed up the price of just about everything, from housing to art to stocks to commodities. However, we are now in a credit contraction and lending has all but dried up. This has led to falling prices in virtually every asset class, because there is less money available to buy things with. Even the assets we buy with cash – commodities – have been falling in price due to the deleveraging effects of a credit contraction.
Money supply is still growing, yes, but at a much slower rate and, given that most new money is created by lending, those levels are likely to retrace further. And if CPI and RPI have peaked for now, while the credit bubble unwinds further, then you’re looking, in the mid-term, at some deflation ahead, no matter how you define the word.
Central banks are still working to drive up inflation
However, it is clear the world’s central banks are attempting to bail out busted banks, and are taking on their toxic loans in exchange for ‘quality’ paper. I don’t believe anyone in their heart of hearts really expects those loans ever to be paid back. Knowing our glorious government’s fiscal record can you seriously expect that Northern Rock loan ever to be properly repaid? I can’t. Not without a serious devaluation of the currency. This exchange of quality paper for rubbish debt is inflationary and central banks have set an ugly precedent of what is effectively debt monetization.
If, as I expect it to, the oil price resumes its uptrend some time next year, while central banks persist in their increasingly desperate inflationary measures, (and if CPI falls, we may get some interest rate cuts too) then you could be looking at a speedy turnaround and a return to inflation. But not the nice sort which sees your house price go up by 15% a year – the sort that sends your bills higher while your wages struggle to keep up.
If I expect to see some deflation, followed by a return to inflation, then what will happen to gold? Well, I would not sell a speck of the stuff, not least because it's the wrong time of year to do so. You should view gold as a currency rather than a commodity, and, as such, it will rise and fall against other currencies. More to the point, we are in a period of huge financial instability. Central banks – with varying levels of success – are intent on debasing their currency. In those circumstances, you want a good 10% of your assets in gold.
Finally, when considering the inflation-deflation debate it’s worth looking psychology and mood. Typically, during inflation – or during a period of credit expansion – the mood will be one of risk-taking and speculation. Money is cheap, we’re making loads of it, come on let’s have a flutter. Eventually, investment starts to lose touch with reality and you get bubbles.
But in the deflationary, post-bubble unwinding, attitudes become more defensive and risk-averse. That is where we are now. People are trying to pay down, not increase debt. They are not buying houses at any price as they were 18 months ago. Banks are being a lot more conservative about who they lend to and how much.
Can you really see a swift return to the speculation we saw in 2006-7? I know I can’t. Too many people have lost too much money and that takes a long time to forget.
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