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The Inflation/Deflation Debate – a Reconciliation

The Treasury is on a wild spending spree with the Fed creating the money that can’t be placed at a targeted low interest rate.  Consequently, the Fed has more than doubled the monetary base in the past year.

Economists trained as monetarists are wringing their hands over the coming wave of inflation due to the excessive money creation.  After all, M*V = GDP (i.e., Money * Velocity), and since M has doubled, it is inevitable that prices have to rise (assuming that V doesn’t fall by half).  In normal times, of course, such actions would be immediately inflationary.  But, as I’ve seen so many commentators say, “these aren’t normal times”.

Let’s approach this from the demand side of things.  When jobs are being lost, aggregate income is falling.  When credit is tight and asset prices are falling, folks can no longer “supplement” their income by borrowing.  When folks are overleveraged, “disposable” income is “saved” to repay debt rather than spent on consumption.  The spending spree in D.C. will eventually have to be paid for by higher taxation which will put a further crimp on consumption.  So, on the demand side in the domestic economy, it appears that there are very powerful deflationary forces at work.

So, why the concern about inflation? The simple answer is that it comes about due to the excessive spending and debt creation in Washington, D.C., which is destroying the dollar’s value in the world.  Inflation will occur, not from the typical demand-pull of the consumer, but from the rising dollar cost of non-labor inputs into the production process.

As the dollar depreciates due to uncontrolled debt creation, then the dollar cost of natural resources and commodities demanded elsewhere in the world are certain to rise.  This includes the cost of goods manufactured outside the U.S., as dollars buy less.  At the same time, the downward pressure on American wages and incomes will continue as American jobs continue to erode.

It is important to distinguish what kind of inflation we will have.  It won’t be the “asset” inflation that we have had over the last decade (real estate and paper assets).  But it will show up as rising costs of commodities, natural resources, and energy.  On the other hand, since consumption will be on a flat to mild growth path, the profit margins of manufacturers selling in the U.S. will be squeezed as raw input costs rise but consumers balk at paying retail prices and retailers have to resort to large discounting to move inventory.  We have seen profits come in better than expected in the second quarter, almost exclusively due to cost cutting.  That’s usually good for one quarter.  So, consumer weakness along with rising raw input costs will impact the profit margins of domestic U.S. businesses.  We all know what that means for the prices of those stocks!

One must also realize that the coming inflation will not raise the value of other existing assets.  Real estate immediately comes to mind, both housing and commercial.  We have seen some stabilization in the prices of low to moderate homes, but there is little expectation that there will be any significant rise in prices anytime soon.  It also appears that high priced homes still have more downward price pressures to weather.  In the commercial sector, with the health of small business in question, rents will continue their downward trend thus pushing commercial real estate values lower.  I see no end in sight for these trends.

In the end, you can think of the inflation/deflation picture this way:  there will be inflation in the things we need/want to buy (based on rising input prices and a devalued dollar), but continuing deflation in the things we already own.  This is certainly true of real estate, and will be true of paper assets as the dollar devalues.  Some protection is available by owning some commodities (although volatile), some foreign currencies, and foreign companies, especially those with significant sales in the developing and emerging Asian economies.

Robert Barone, Ph.D.

September 1, 2009

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.


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