Wednesday, November 25, 2009

The Great Debate: Inflation vs. Deflation

The Great Debate

I would like to return to a subject we have touched on in the past: the inflation vs. deflation debate. Few things matter more in the world of investing than getting this call right, and the fact is some very smart people have come to very different conclusions while looking at the same data. So what's really behind this debate?

What spooks everyone, of course, is the tremendous increase in money supply, which you can see below:

Source: IMF, Bloomberg

In and of itself, though, more money does not cause more inflation. The monetarists - who, again, I love and respect - got this part wrong. More money in circulation only tends to result in inflation when people are actually doing something with it, which is otherwise known as the velocity of money.

To understand why, consider first how money is created. Popular imagination has it that the Treasury prints money, but that's not how it happens. The Treasury has little to do with it. What actually happens is that the Federal Reserve "monetizes" debt, which is to say they go out and buy government debt from banks at market prices. The debt goes back on the Fed balance sheet and the cash goes to the banks.

The key piece then becomes, what do the banks do with the cash? Normally, they lend it out and the money then has a "multiplier effect" through the economy since banks can loan $10 for every dollar in reserves. But that's not happening now. Banks are licking their wounds and hoarding cash to rebuild their balance sheets. As a result, the money is not yet "out there" chasing goods and services. Furthermore, the money is already out in the real economy is being hoarded to repair business and personal balance sheets. Are you spending as much money as two years ago? Didn't think so.

So, the deflation vs. inflation debate is really just an argument over when (and how much) the velocity of money recovers. In the graph below, you can see how much it has declined lately. This is why there's no inflation right now.

Source: OECD, Bloomberg

But we need to pull the onion back one layer further. What will cause velocity to come back? It turns out that velocity is highly correlated with employment, which is quite logical. People don't spend when they're out of work. Here's the history:

The correlation here is 0.75, which is really high for anything in economics land.

So, inflation won't kick in until employment starts to recover. When will this be? Don't know, although much of the policy coming out of Washington is totally anti job creation. It's a fair bet that employment doesn't come roaring back, which means inflation is not an immediate threat.

But, Scott, you have been ranting about the inflationary threat for months now. What gives?

Inflation is a huge threat, it just won't happen in the next few months, and maybe not for a year or two. Employment (and therefore velocity) tends to be mean reverting. It will return, and when it does, the Fed will almost certainly find it has overshot the mark. It has to overshoot the mark because the alternative - deflation, depression - is far worse. And then there's the fact that the government owes $12 trillion that it would very much like to inflate its way out of.

My friend Mike Kelly said it best: it's like you get to a party late and everyone else is already a couple of drinks deep, so you decide to play catch-up. Pretty soon everyone else is looking at you like you have three heads and your wife is giving you the hook. You overshot the mark. (I'm told this happens to, you know, other people.)

Anyway, it's last call and the Fed has its face in the punchbowl.

The Fed, Later That Same Evening

(Wonkish aside: I am not a proponent of the so-called Phillips Curve, which states that there is a long-run relationship between employment and inflation. The relationship simply doesn't exist over time. Having said that, because of the extraordinary amount of money being pumped into the system, employment in this particular cycle will be the trigger that causes velocity, which will be a key trigger that causes inflation. The other triggers, as I've covered in previous letters, are emerging market demand for raw materials and a socialist-driven supply drought.)

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