Inflation vs. Deflation Debate

In this environment, we anticipate that inflation will remain low. Indeed, given the sizable margin of slack in resource utilization and diminished cost pressures from oil and other commodities, inflation is likely to move down some

Early this morning, that’s what Fed Chairman Ben Bernanke told a Congressional committee charged with overseeing (?) the economy.

Is he right and inflation is not a concern now? Or is he wrong and Inflation is a much bigger risk than he’s letting on?

These are the questions weighing on many folks’ minds right. And rightfully so too. After all, the difference between getting it right and wrong will be big.

If you bet correctly, the window of opportunity is wide open.

If inflation wins out, now is one of the best opportunities in years to invest in farmland, toll roads, and other “real assets” which perform exceptionally well during inflationary times.

If deflation wins out, now is the time get out of everything. Cash and long-term government bonds will be top performers.

That’s why now, with opinion still sharply divided, is time to get positioned. First though, we’ve got to determine which way to go.

Let History be Your Guide

Over the past few months we’ve looked at all sides of the inflation/deflation argument. We’ve discovered that all bubble-booms throughout history eventually end in deflationary busts. We’ve also watched the Federal Reserve go to unprecedented lengths to increase the money supply in an effort to battle deflationary forces.

Our current situation, however, is not like every other bubble-boom-bust. So many comparisons have been made to the Great Depression. But most of them fail to account for one key difference, massive government spending around the world.

The current levels of U.S. government deficit spending are well documented. After a year of nearly $1 trillion “stimulus” packages and aggressive loosening of monetary policy, Congress is now set to debate spending another $4.1 trillion. While they haggle over whose friends will be taken care of the most, the administration tries to close every tax loophole in exchange for a short-term cash infusion, and everyone pats themselves on the back for finding $100 million in savings, there are much bigger consequences to be dealt with.

The deficit resulting from the record budget spending is expected to be between $1.7 trillion (best estimate) and $2.8 trillion (highest estimate I’ve seen – probably much more reasonable as well) after the new spending plan budget is passed.

Of course, every administration for the past 50 years has proven “deficits don’t matter” so that’s not much of an issue for too many people (enough to matter right now anyway).

That’s small compared to the real issue at hand anyway. The big problem is the outlays the government is about to make – whether they’re funded by increased taxes, printing money, or debt (or all of the above).

Desperate Times and Desperate Measures

Under the guise of saving the economy, the U.S. government has committed itself to spending so much money that GDP growth is inevitable.

This is not a new strategy. It has been a few times before in U.S. history. Just take a look over the past 150 years. The last few times U.S. government spending reached these levels (as a percentage of GDP), the consequences, which were always the same, followed close behind.

In 1861, the Union printed more money, borrowed everything it could, and spent it all to fight back the “rebels.” Inflation between 1861 and 1865 ended up at 117% for the period. That’s 16.7% on an annualized basis.

In 1917, President Woodrow Wilson aggressively emptied the government coffers in World War I. Prices increased 126% between 1917 and 1918. That’s 50.3% annual rate.

In the 1940’s we went through it again. The U.S. involvement in World War II forced another surge in government spending. This time the prices rose 108% between 1941 and 1945. That works out to a 15.7% annual rate of inflation.

Then in the 1960’s, during the quest for the “Great Society” amidst the Vietnam War, the U.S. government stepped up spending in a big way. The end result was the “lost decade” of the 70’s and stagflation which followed.

See a pattern here?

You’re not the only one. That’s why I’m so perplexed the markets, once again, expect it really is different this time.

It’s no secret the government is spending big. History shows the results are always the same. Still though the market doesn’t seem to be too concerned about the inflationary effects of what will surely follow.

The market’s refusal to accept reality, however, could be starting to come to an end.

A Changing Tide: Bonds Don’t Lie

Although the stock market gets all the headlines, the bond market is actually far better at predicting an economic recovery, expected inflation, etc. It’s just so much bigger and more efficient.

That’s why I always pay close attention to it. And a funny thing happened this week. Something which showed the tide could be turning when it comes to the deflation/inflation debate (well, at least where people are placing their bets – I’m always weary of people who don’t “eat their own cooking”).

This week the yield on the 10-year Treasury bond climbed to 3.18%. That’s just shy of a five-month high of 3.21% and could be forecasting inflation on the horizon. Remember, bond yields move inversely to bond prices. So the yield increase means the selling pressure is increasing and/or the buying demand is declining.

In the chart below, you can really see the decline in the value of the long bond as tracked by the Barclays 20-Year Treasury Bond ETF (NYSE:TLT):

Long-term government bonds have experienced a pretty strong sell-off since the credit crisis sent bond prices soaring.

Why would bonds be selling off, you ask?

Well, there are two reasons.

The first is the economy is showing signs of improvement. As the economy shows some “green shoots,” investors are likely willing to take on a bit more risk. As a result, they sell out of government bonds and move into riskier assets like stocks and corporate bonds. Both of which have been doing exceptionally well lately.

The other reason is inflation. A bond’s yield must be equal to or higher than inflation expectations. If it wasn’t the bondholder would be getting a negative return. Although this has happened in rare instances in the past, most bondholders are not willing to accept a guaranteed loss. So when inflation starts to become a concern, bond prices fall and yields rise.

Whether this is the big one when inflation really starts have impact or it’s is a few months or years down the road doesn’t really matter here. Inflation is coming and it’s never too late to get prepared.

Winning Either Way

In the past few of years we’ve seen a lot of changes. Politics has moved into a greater role in our personal and business lives. As it has, the divide between the capitalists and socialists has grown even wider.

We could even be witnessing Alexander Tyler’s prediction play out right before our eyes. The Scottish philosopher warned of democratic governments:

A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy.

Slowly but surely, it looks like the “majority” has figured it out. And the inevitable result will be sharp increases in government spending to appease the majority. There are only a few ways to fund that spending. As we looked at a few months ago, there will be three ways:

1. Increase taxes
2. Borrow more money
3. Print more money and inflate the debt away

At this point, it’s likely we’ll get some increase in taxes (remember, it’s the “patriotic” thing to do), a lot more government borrowing, and a lot of money printing and inflation. They’re the politically easiest choices to make.

Its times like these which I can get exceptionally frustrated. When I first started investing, I enjoyed looking for great ideas, great business models, and great products.

There was nothing like uncovering a successful business which was meeting its customers’ needs and the customers were happy purchases and on its way to creating vast amounts of shareholder value.

But when all the forces are pointing towards a huge wave of inflation coming – an annual rate of 10% to 20% given the historical ranges – you’ve got to take what the market gives you. And right now, while the inflation/deflation debate rages on, it’s giving us a chance to protect ourselves from the coming inflationary wave inexpensively and maybe actually profit as well.

By Andrew Mickey

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