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Which is it, Deflation or Inflation?

By: Steve Johnson

11/14/2008 - 52 Comments

Economists are scrambling to understand the direction of the economy to provide investors the critical information they need.

Just a few months ago, in August inflation was rising very fast hitting a five year high of 5.6% and was projected to continue to climb. Then in August, the global market deleveraging began to deflate prices of just about everything.  Inflation is now expected to drop down to 2.2% for the year. 

The economy data that economists are analyzing is changing direction so fast that it’s very difficult to have a clear and credible explanation of the future direction of the economy.  The only reasonable analysis has to be based on previous data point, graphs and economy indicators, which can be used to explain the present but do they adequately explain the future?

One of the biggest debates is if we are headed into a period of deflation or inflation.  In the Great Depression, which lasted 25 years, the period was primarily deflationary, while in the 70’s recession, which lasted about 10 years, the period was primarily inflationary.  The biggest different was that during the Great Depression, the government didn’t have as much control over the money supply because the dollar was still tied to a gold standard, while in the 70’s the government removed the gold standard and increased the money supply in an effort to print and spend our way out of the recession.

So, which is it going to be this time?  That is the million dollar question and if you guess it right, you could easily make a million dollars.

The Present Condition Is Deflation

Currently, we are in a deflationary period and there is no doubt about that. House and car prices continue to decline year-over-year, as the foreclosures continue to increase and the auto industry is on the brink of collapse.  But the risk is growing that the world is becoming tired of borrowing America money, which is a major reason for the $700 billion bailout. 

Many of the institutions being bailed out are owned by foreigners.  If America does not continue to pay its debt and global economic conditions continue to worsen, many nations may stop investing in America and abandon the dollar altogether - which would cause the dollar value to sink, resulting in massive inflation.

This is the current path that we are on with no sign of changing direction in the Obama administration.  Therefore, a prolonged deflationary period (decrease in money supply) is highly unlikely. The government will continue to increase the supply of money at a faster and faster rate as it gets more and more desperate to revive the economy.

The Future is Inflation

The actions of the government will lead the economy out of the current short period of deflation, into a long period of inflation. The current deflationary period will continue until the assets (cars, houses) are liquidated - perhaps another year. But after that, the highly inflationary monetary policies of our government are likely to overwhelm the market with inflation.  The government is trapped with very few options left accept to increase the supply of currency by printing money to pay for debts. The October budget deficit hit a record $237 billion.

Therefore, in time inflation will overtake deflation. The combination will be disastrous.  The deflationary period of today is causing millions of job losses as consumers crater as they realize the days of easy money are gone. Then soon after, the inflationary period will return, with spiking interest rates so that even if you did have some money left it will cost you more to get a loan and your money will have far less value.

How to Play the Cycle

This environment is very difficult for an investor to make decisions without getting trapped in either period.  The best strategy that I can see is to use the current deflationary period to purchase inflationary protection assets (gold, oil) and perhaps even cheap assets (houses) with low interest loans, so that when the inflationary period comes the loans on your assets (houses) will be reduced in value while your inflationary protection assets (gold, oil) will increase in value.  In this period of wealth destruction it is going to be very difficult for investors to perserve their wealth, let alone increase their wealth.  Many of the best investors, like Warren Buffett, have already lost billions.

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