Inflation vs. Deflation: Is There Any Way to Determine Which One Will Win the Economic Tug of War?

With the domestic and global economies currently in a historic state of flux, one fundamental question weighing on every investor’s mind is: who will win the current economic tug of war? Inflation? Or Deflation? Getting the answer right will have serious consequences for both individual and institutional investors, probably for decades. While nobody can know the answer until it arrives, of course, we can hedge our bets in any of several ways: by tossing a coin, listening to the opinions of pundits (who can’t seem to agree on anything whatsoever), or taking a logical, structured look at the connections between inflation and changes in interest rates, debt, consumer habits, the policies of the Fed, and the actions of the banks. It’s my opinion that we’re not likely to have a strict “either/or” scenario, but rather a ‘both’ scenario in which the proper question to ask isn’t “which one?”, but rather “what circumstances favor the arrival of one vs. the other?” If we have some understanding of what triggers either inflation or deflation, then we can look for clues as to how strong or likely those triggers will be and have a rational basis to predict whether inflation or deflation is headed our way. As circumstances change, we can look again and see whether the triggers, and therefore the odds, have changed, and plan accordingly. That’s a much more dynamic and fluid way to approach the question of inflation vs. deflation, in my mind.

To help cut through the morass of confusing information on actions, policies and circumstances that may affect the odds of having either inflation or deflation, I’ve created a table in which I’ve sorted out the connections as I see them, and made them easy to understand and simple to use. If my table is anywhere close to being correct, then it would provide a quick and logical reference for taking inflation and deflation into account when making investment decisions. First, let’s run through a few things you should be familiar with to discuss the issue, and then let’s move on to my table and see what it tells us!

Like Goldilocks’ Three Bears: Three Types of Inflation

To better understand inflation, it’s helpful to divide it into three categories: Price inflation, asset inflation, and monetary inflation.

Price inflation is the one which most of us are familiar with. This is is the simple and obvious type in which the cost of consumer goods (like bread) and services (like haircuts) goes up. This is the inflation that the Fed claims it’s currently trying to get “just right” at about 2% per year.

The second type of inflation is a subset of price inflation called asset inflation. Asset inflation refers to the increase in cost specifically of the things that grow or preserve capital.  Simple and common examples of assets include stocks, bonds, personal businesses, and maybe our homes (although your home may not actually be a financial asset. It depends. I’ll tackle that in a separate blog. But for now you can follow convention and treat it as an asset). To give a simple example, a share of Acme Tech Overlord Co. would be considered an asset because it would be expected to grow your initial investment if you owned it. (As an aside, I find it interesting that we call certain items assets even though we know that under certain, and not very rare, circumstances, they will actually lose us money. This is an example of subconscious conditioning to accept a lie as a reality.)  Getting back to the point, though, if you purchased a share of Acme for $150 last year and this year the market will buy it back from you at $300, some people would call that inflation of value in that share. Yes, but what kind of inflation is the critical question? Because the value of your stock asset is supposed to grow, or appreciate, over time, it would be suffering from price inflation only if your price gains exceeded any rise in the underlying value of the share for the period during which you held the stock. So if the ACME company doubled its output and sales over the past year and looks poised for even greater growth in the future, then a doubling in share price would be due entirely to asset inflation (absent any ‘creative accounting’, of course). When I refer to asset inflation, I’m referring to this ‘natural’ base rise in price that occurs because of an increase in the inherent value of the underlying asset. A rise in cost over and above the inherent rise in appreciation of the underlying asset would be price inflation.

The third type of inflation, and the type with which most of us are least familiar, is monetary inflation. Monetary inflation is simply a fancy term for when the government prints new money out of thin air, backed by no assets or value whatsoever, and puts it into circulation alongside, and in addition to, existing dollars. Monetary inflation, combined with the speed at which the population grabs that money and runs out to spend it, causes price inflation. There is a term for the rate at which a dollar turns over as it passes form hand to hand; it’s called the velocity of money. While the velocity at which money exchanges hands may not, at first glance, seem to have much to do with the rate of inflation, the relationship becomes more clear if you consider what would happen if everybody put every new dollar the government was pumping into the market under their mattresses and never spent it. All the extra money might as well not exist! If none of the extra money actually changes hands, it will have no effect on the economy. If, on the other hand, it’s very “loose” and spends around, if you know what I mean, then everybody who has anything to do with it can be said to be more wealthy as a result. This turnover is the basis for the term ‘money multiplier’, whereby the economy is said to grow if dollars change hands more often and more quickly. The money doesn’t actually multiply, but it gets counted over and over as it travels from one owner to another. This not only allows more businesses and people to exist on the same amount of money, but is a great boon to governments who can brag about growth in their economies and levy higher taxes even if there aren’t actually any more dollars spending around.

How Do We Keep Tabs On Loose Money?

One of the unwritten, but implied, mandates of the Fed (and the bullion banks, but they are another issue), is to manipulate both the money supply and investor expectations so as to keep the markets afloat no matter what. Unfortunately, because of the extraordinarily complex nature of the financial system, and because several parts of it are run in almost complete secrecy, hazarding a guess as to where the various forms of inflation are headed is extremely difficult at best. However, if we resign ourselves to accepting a simplified structure, then we can create a table of sorts to at least lay out the main visible components of the system and explore how they’re linked together. Once that’s done, making logical and data-based inferences about where each type of inflation is likely headed becomes easier. Hopefully this will help us sort out some of the confusion, such as why prices aren’t going up at the grocery store as much as one would expect given how many dollars have been printed out of thin air in several attempts to rescue our economy.

A Simple Confusion Reduction Table

The table below is my attempt to organize the factors and circumstances that, as I understand them, affect the three types of inflation. It’s divided into an “If…And…Then” format to be easy to follow as I puzzle out how the various possible actions of the Fed, combined with the various possible reactions of the public, would combine to create inflation or deflation. This is by no means a perfect, comprehensive, and final assessment of the issue, and it leaves a lot of factors out. But I think it rests on the biggest moving and shaking parts of the economy and creates a picture that is generally in the right ballpark even if all other issues are factored in. At any rate, it’s really a starting point that can be expanded and refined as new data becomes available and my understanding of the links among the various factors improves. Reader comments on these points are welcome.

Base Assumptions

As with any sort of speculation or theory development, we have to start with some base assumptions. I’m choosing to start from current economic reality:

• America’s national debt is extremely high and growing. While sources differ in regard to exactly how great the debt is in regard to various measures of economic health (usually the GDP) and where the “tipping point” at which economies can no longer support their debt, lies, for my purposes, exact numbers don’t matter. What’s important is the overall status of the economy, the trends, and the size and momentum of those trends.
• Because of the size of the debt, as well as the annual deficits, and the fact that both are growing rather than shrinking, interest rates absolutely must be kept near zero nearly in perpetuity, or even go negative. I speculate that they will skyrocket shortly before the final collapse of the American and major global economies, with my reasoning explained in the table.
• Mirroring the national debt, American consumer/household debt is also very high. Again, exact numbers don’t really matter as the point of my charts is to serve as a thought exercise, to better see the linkages between Fed’s actions, the public’s aggregate response, and the overall outcomes.
• America is mired in a service economy, with no realistic policies, plans or resources with which to bring back a solid manufacturing economy. In addition, a deteriorating academic infrastructure decreases prospects of growing or even maintaining a global lead in a science and technology based economy.

OK, without further ado, here is my inflation/deflation scenario sorting table:

IF	AND	THEN
The Fed gives money directly to consumers (i.e., “stimulus’)	Consumers use it primarily to pay off debt and bolster savings (while keeping overall household spending relatively constant)	Near term: Monetary inflation with little consumer goods price inflation (Because price inflation will be in proportion to the small amount of stimulus being used to purchase goods and services in excess of what would have been purchased without stimulus cash.)Most assets will neither inflate nor deflate. Credit card stocks, however, will deflate as consumers pay off high-interest charges and tighten belts.Overall economy will neither grow nor shrink while debt is being paid off. (Banks will have more to lend, but fewer businesses will open or expand if consumers aren’t spending more). Markets will stagnate as potential fresh cash finds its way back to creditors and savings accounts, instead. The markets will cry to the Fed for more monetary easing and/or lower interest rates and the Fed will oblige, unless crashing the system serves a larger political goal. Medium term: Price inflation rises as consumers pay off debts and decrease saving to put dollars back into the consumer economy. The rate of monetary inflation eases, though total monetary inflation probably continues because the markets require constant infusions of new money to keep rising. Debt- laden, unprofitable zombie businesses will continue to survive and produce a drag on economic growth because consumers will be once again consuming, while higher interest rates (the cost of which would crush the businesses) will be suppressed by the Fed. Longer term: Excessive rates of malinvestment and excessive numbers of zombie businesses will put such a drag on the economy that “direct to the people” stimulus will again be required, but this time no amount of stimulus or interest rate suppression will rescue the economy. Interest rates will soar, despite the intervention of the Fed and the world’s other central banks, and the value of the dollar will take its final collapse
The Fed gives money directly to consumers (either by check, or by electronically crediting bank accounts with ‘electronic cash’)	Consumers use it primarily to purchase assets instead of paying down debt (and assuming relatively steady  everyday household spending before and after stimulus)	Near Term: Monetary inflation with little price inflation because most of the cash is going into assets, not consumer goods and services. Asset inflation, even bubble if stimulus is large and mostly directed to asset purchases. Credit card stocks will soar in proportion to the amount of money going into ccard stock purchases and amount of new debt taken on by consumers. Neither inflation nor deflation in overall economy b/c few new dollars are chasing consumer goods (they’re going into assets, instead). Banks have neither less nor more to lend b/c consumers aren’t saving. Few businesses will open or expand. Medium term: Asset deflation as bubble(s) pop and holders must simultaneously sell assets into declining market. High probability of price deflation as asset holders lost high proportion of their wealth and can no longer maintain their usual levels of consumer spending. High risk of yet more government “stimulus” to bail out consumers hurt in asset bubble blowout, starting process over from beginning. Longer term Debt, low interest rates, and the high number of zombie corporations together place such a drag on the economy that the dollar loses all worthDespite the best efforts of the Fed and major central banks, the dollar will lose its value, interest rates will explode and the synchronized global collapse will occur.
The Fed gives money to the banks to stimulate the economy by lending more	Consumers fail to take out more loans because they’re already having difficulty managing debt from previous loans -or- Banks refuse to make new loans to consumers and businesses who are higher risk.	Near term: Neither inflation nor deflation as new dollars aren’t released into the market, or mild deflation if consumers focus on getting out of debt instead of consuming more Medium and Longer Term: The Fed, the banks, or both may lower interest rates to stimulate demand for consumer and business loans.Lower interest rates may increase demand for loans, especially for rolling over of existing debt. The money saved by lowering the interest payments on debt is likely to be spent, causing mild inflation.Housing bubble likely to form Longer term: Default rates on homes and businesses both become increasingly likely
Ditto	Consumers and businesses have room to take on more debt and choose to do so	Near term: The economy experiences a “growth spurt”. Monetary inflation increases in proportion to the number and size of loans created. Asset inflation increases in proportion to the number and size of loans created, as well as to the proportion of the cash used to purchase assets. Price inflation increases in proportion to the number and size of loans created, as well as the proportion of cash used to purchase consumer goods Medium term: All of the above. Asset and price inflation continue modestly upwards as growth is sustained at reasonable levels. Since the bulk of the loans went to creditworthy consumers and fundamentally healthy businesses and entrepreneurs with solid business plans, relatively strong economic growth is maintained for a long period before the economy matures and slows. Longer term: Monetary inflation slows as strong, mature businesses with fewer borrowing needs begin to dominate the economic landscape and consumer consumption of their products reaches a stable plateau Same for same for asset and price inflation. Long-term stability replaces growth
The Fed gives money to the banks and requires lowering of lending standards to encourage consumer and business loan uptake. May be accompanied by lowering of interest rates	Higher risk consumers and businesses begin taking out more loans	Near term: Economy sees a “growth spurt”. Monetary inflation increases in proportion to the number and size of new loans made from freshly printed money. Price inflation, like monetary inflation, increases in proportion to the number and size of previously ineligible consumers and entrepreneurs who now receive loans, but also in proportion to the speed (velocity) at which they receive and spend them. Medium term: Asset bubbles in housing and stock market begin to form. ‘Unicorns’ and other nascent manias begin drawing interest from investors moving away from lackluster returns in a maturing/slowing economy. Monetary inflation increases if interest rates drop, encouraging and businesses and consumers to extend further or refinance at cheaper rates. Rate of price inflation will either increase or decrease depending upon interest rates: If interest rates rise, a wave of business closures, defaults and consumer bankruptcies will drive inflation lower, or even cause deflation. If interest rates stay steady, inflation will decrease, but if at a slow enough rate, the economy will adjust and avoid significant long-term effects. If interest rates decline, price inflation may increase mildly as failing businesses and debt-laden consumers will roll over loans at cheaper rates, and use the savings to fuel investment or consumption Longer term: Asset inflation increases dramatically until asset bubbles reach their peaks. Sudden, rapid and severe asset deflation follows pop of the bubbles. Monetary inflation increases to the extent that companies take out loans to give the appearance of growth and lure in more investors, and consumers increase loans to service previously acquired debt. Monetary inflation stops as bubbles pop and businesses and consumers stop taking out loans. Price inflation increases as long as businesses and consumers are continuing to take out loans. Price inflation halts as bubbles pop. Deflation may occur at this point. Otherwise, inflation will occur if the Fed begins to furiously print money and stimulate price inflation to paper over the asset deflation.
The Fed gives money to the banks and simultaneously offers them interest to keep it as “excess reserves” in their mandatory reserve accounts with the Fed.	Banks accept the Fed’s offer and park the stimulus money in their excess reserve accounts because earning the lower level of returns risk-free is likely to be more profitable in the long run than giving out loans	Near, Medium and Longer Term: All forms of inflation should remain unaffected if the banks don’t make loans and consequently don’t release stimulus money into the economy

I hope my table is helpful to you if you’re attempting to make spending and asset allocation decisions based on whether we will be encountering inflation or deflation in the future. I think this table at least gives clues as to where to look for underlying drivers of inflation or deflation and how strong they are (for example, examining lending data to get an idea of how much new lending banks are engaging in and comparing that to the total size of the stimulus to get a rough idea of how much new cash is actually coming into the economy and how that compares with what the government wants). Reader comments are welcome.