Inflation, Deflation or Reflation?

The question as investors we have been focused on for some time is whether we end up with inflation, or deflation, and what that endgame looks like. It is one of the most important questions an investor must ask for the last 2 years, and getting the answer right is critical.

The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent US inflationary policies. Inflation doesn’t stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult.Return to discipline in the current environment would be too painful and dangerous.

The inflationary implications of the twin deficits (current account and fiscal), as well as the steady increase in private debt, have been moderated by the integration of emerging markets into the global economy. The massive increase in industrial output from China, India, and others has enabled persistent credit inflation in the US to occur with virtually no consequence to date (other than periodic asset price bubbles and shakeouts). How long the disinflationary impact of emerging-market productivity growth will persist and how long these nations will continue loading up on Treasuries, will be instrumental in determining the course that the Great Reflation will take.

Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country’s output. This can possibly be achieved by methods that include reducing tax, changing the money supply, or even adjusting interest rates. Just as disinflation is an acceptable antidote to high inflation, reflation is considered to be an antidote to deflation (which, unlike inflation, is considered bad regardless how high it is).

Tougher regulation is surely appropriate, but it will not stop the next inflationary run-up unless the system is fixed. In the final analysis, newly minted money and credit must find a home somewhere.

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage – from banks to consumers to supposedly blue-chip companies – and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted.

The Great Reflation Experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve’s balance sheet.

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However, much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest-rate shock.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or nonexistent, and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.

In the next six to 12 months we look for a weak but recovering US economy, a continued deflationary price environment, pretty good asset and commodity markets, and continued narrowing of credit spreads. This view is based on the assumption that the new money created has to go somewhere, a stable to modestly falling dollar, and an anemic world economic recovery next year.

So, what do you think is the most foreseeable scenario for 2010-2012?
Let me know your comments.