SOS Myth on Inflation

By Jason Farkas 21 Oct 2009

An increasingly loud chorus of investors expects the imminent demise of the US dollar and US Treasuries. They also expect that an exploding monetary base and the US’s structural problems will lead to massive inflation. This opinion may prove to be correct in the very long run, but evidence continues to mount that a deflationary phase will come first.

1. Inflationist Arguement

First, let’s summarize the inflationists’ view: Debt in the US is out of control, and the actions of the Fed, Treasury and Congress will continue to offset any deflationary slowdown in the economy. Deficit spending and interest rate cuts from almost every nation on the planet are inflationary. The US’s exploding monetary base, which has more than doubled over the past year, and large fiscal deficits, which may exceed $1.2 trillion this year, will eventually devalue the US dollar and cause foreigners to flee the Treasury market. The interest payments on our national debt will rise because of this exodus from the US Treasury market, which will weaken the dollar further.

2. Debunk by Deflationist (point to point)

We believe that people are incorrect to always look for inflation. At rare times, deflation happens, and here are the two key points which show holes in the inflationists’ near term outlook for inflation.

i. Treasury markets are attracting record demand -- Until foreign central banks flee from US Treasury debt, one plank of the inflationists’ platform is missing. Wholesale abandonment of US Treasury debt would cause interest rates to soar, which would raise the cost of capital in the US. But the data clearly shows that foreign central banks have not abandoned the US Treasury. As the chart indicates, foreign net purchases of Treasuries hit an all-time high at $100.53 B in June 2009, with China and Japan leading the way.


ii. Collapse in consumer credit -- The US monetary base has expanded, but banks have raised lending standards and consumers are spending less. Consumer credit has fallen by $60 billion in the last five months, the sharpest drop in more than 50 years, and the new trend towards less spending is likely to continue. This drop in consumer credit should warn the inflationists that a new trend is in force -- one of deleveraging, which runs counter to the idea of inflation. The expanded money supply is potential inflation, but it is impotent if the credit is not actually being extended. As Bob Prechter points out in Conquer the Crash, “The ultimate success of the Fed’s attempts to influence the total amount of credit outstanding depends not only upon willing borrowers but also upon the banks as willing creditors.”

3. How do we know if Inflationist is correct?

If inflationists are to be correct, we will likely see confirming action in the currency and bond markets. While not required, an impulsive (in Elliott wave terms) sell-off in the US dollar and Treasury bonds would at least be a warning that inflationists were on the right track. But Elliott wave patterns in the US dollar continue to suggest a significant bottom at hand. And in the Treasury arena, along with the scramble for cash, investors are likely to scurry away from risky assets into the one US market that’s still rated AAA -- US Treasuries.

Just as accounting scandals and fraud were unearthed towards the end of the technology collapse from 2000-02, be prepared for similar bombshells to explode along with Primary wave 3 down. (My apologies to non-subscribers for using another potentially unfamiliar term.) They will come from areas where inflationists haven’t thought to look, such as emerging markets, derivatives, high-frequency trading and terrorism. Only after bombshells begin to burst will most investors realize that a slumping economy and deflation are underway. And only once deflation has been embraced by the mainstream is the point when inflation will become likely.

MyView

• Inflationist says deficit spending and interest rate cut will cause inflationary (deflationist says consumer spending drop, credit drop, saving increase, bank reserve increase because not lend out)



• major QE and fiscal deficit will eventually devalue US Dollar and cause foreigner to flee Tresuries (On contrary, June 2009, net purchase of Tresuries by China and Japan)



• interest payment will rise and further weaken the US Dollar (so far no major sell-off of US dollars and Tresuries bonds)

Is the arguement above convincing enough? Well time will tell, get your portfolio prepared, perhaps a wiser move is based on deflation first then inflation later (couple of years down the road)