As much focus is placed on America’s unemployment rate which is poised to hit 10% this year, investors with long term horizons are already taking their binoculars out to see what the world will be like in the post-crisis era.  Their main concern is whether all of the money that governments around the world have been pumping into the world economy will result in hyperinflation;  inflation that runs out of control.  Let’s first try to understand inflation a little better, and then we’ll look at whether the dynamics of the current environment are in favour of an era of high prices. 

Inflation – a bad name until now:

Inflation has gotten a lot of bad press in the past.  On the milder side, we have the oil shock that the U.S. experienced in the 1970’s.  In the 1920’s, the damage that inflation had inflicted on the Germans was simply ruthless.  It cost 60 German Marks to buy 1 U.S. dollar in 1921.  In two years time, it cost 4,200,000,000,000 Marks to buy 1 U.S. dollar. 

U.S. inflation in the month of February was positive after consecutive months of price decrease.  The market embraced this as “Some good news finally”.   So... what happened to inflation being the ultimate evil? 

Understanding Inflation:

Inflation does not cause any problems.  It is the result of our day to day economic activities; it is when supply cannot meet demand.  This can happen when consumers demand too much or when producers cannot supply enough.

Small doses of inflation are good for the economy and are necessary for economic growth.  Inflation gives businesses pricing power and when businesses make a profit, they hire more people who will end up buying more products and services.  Businesses then hire even more people and invest more in equipments to meet the additional demand.  This cycle needs to be sustained to keep the economy growing while ensuring that it doesn’t run too fast to avoid bubbles from forming.  Canada has a target inflation rate of 2%. 

On the other side of the coin, businesses will cut cost when prices fall to maintain a profit (or just to break even).  Layoffs are almost an inevitable part of cost cutting measures and when people lose their jobs, they consume less, prices will fall further, and the economy enters into a deflationary cycle.   Authorities will tell you that they would much rather battle inflation than deflation.  They can easily manage inflation with monetary policies such as raising interest rates, requiring banks to maintain higher reserves, etc. 

On the other hand, deflation, which is associated with economic contraction, cannot always be fixed by the simple act of pumping more money in the system.  Governments need to go out there and actually spend money to kick start an ailing economy.  Under stimulation will not work, and over stimulation will cause unwanted inflation.  Given the difficulty in finding the right balance, I argue that governments would rather err on the side of inflation and deal with it later than have deflation persist.  Inflation of 5% or even 10% will cause people to think twice before buying that BMW or going on vacation.  But, they will at least have enough to get by.  If people don’t have a job, it doesn’t matter how cheap things get.   

The Current Situation:

The Obama administration will be pumping U.S. $787 billion into the economy by means of tax cuts and expenditures.   U.S. GDP was valued at $14.26 trillion dollars in 2008 with an annualized drop of 6.2% in Q4.  Excluding multiplier effects, the package is worth only 5.5% of GDP.   In other words, the stimulus package can only undo some of the price fall over the past few months at best; no threat of inflation here.

Some take the signs of inflation in February as indication of the U.S. economy bottoming out.  While I also take it as good news, I also take caution not be overly optimistic and jump the gun on major purchases or investments.  Let’s borrow those binoculars from the long term investors and look back a couple of months.  From August 2008 to February 2009, prices actually dropped 5% for the urban consumer in the U.S.  The Inventory to Sales ratio was 1.25 in Jan. 2008 vs. 1.43 in Jan. 2009, suggesting that businesses are struggling to move inventory out of their warehouses.  In an economy where over 70% of GDP relies on consumer spending, we should be more concerned with the risk of falling into a price deflationary spiral than speculated hyperinflation that may not be any real threat in the end.   On a global scale, the G20 summit came up with a resolution to make $850 billion available to the IMF.  That money is worth only 1% of world GDP so again, it shouldn’t raise a red flag for inflation. 

The U.S. government has injected capital into financial institutions shot after shot.  With the unemployment rate flying like there’s no gravity, that money is not going to start circulating in the economy anytime soon.  People need to have income in order borrow.  When people have income, they will get loans to buy a house or a car; you don’t need to force them (in fact, you can’t force them).  It shouldn’t work the other way around where you let credit run loose in hopes of stimulating spending and create new jobs.  This is how we got into this mess in the first place.  We probably won’t see the loans market being very active until unemployment eases and by then, the banks will be much more stringent with their lending practices.  The same idea can be applied to U.S. government scooping up US$300 billion of bonds to help kick start the loans market.  It won’t work. 

The Outlook:

Oil prices have fallen to the $50 range and the CRB Index (measuring the price of commodities) has fallen by 31% year to year (I took the values as of Mar. 27).  With eager job seekers, businesses that face a shrinking market for their products are also seeing their costs come down.  As businesses that can’t compete throw in the white towel, surviving businesses will be presented with cheap raw materials, available labour and enough market share to make a profit (with low prices, you will need to rely on volume to generate enough revenue).  Once they make a profit, they will hire more people, who will spend more money, and we enter another boom cycle.

Don’t forget that this is not a cyclical recession but one that rewrites the rulebooks.  Export driven economies will no longer be able to rely on American consumers.  Americans will not spend beyond their means and may even start to save money again.  Whether we will reach the bottom and stay flat (aka an “L-shaped” recession) or bounce back up will largely depend on whether the next wave of consumers that many speculate is in China will be able to lead the way.  We cannot be certain of China’s ability to lead the next boom.  But, we can be sure that the risk of deflation is real, the risk of hyperinflation is only probable and distant, and with interest rates at historical lows, any inflation can easily be corrected. 

How does this relate to your investment portfolio?  I need some time to give it some thoughts and I’ll share them with you in my next article.

Stay tuned!