Inflation or Deflation

August 4, 2012

Topics: Inflation or Deflation

There has been an ongoing debate between economists about whether we will have inflation or deflation. And as funny as it may sound I think that they are both right â I believe that we will have both. The key for investors is timing.

The natural outcome of a recession is deflation as a result of falling asset prices and cuts in discretionary spending. But governments have responded to the recession with inflationary spending programs and stimulus packages. These two giant forces are pushing up against each other and as a result we see glimpses of inflation and glimpses of deflation â all at the same time but in different parts of the economy.

Much of the developed part of the world is in a phase of no growth, slow growth or recession and if you combine this with the deleveraging of the private sector you have real deflation on your hands. This is the reason why central banks have been able to print so much money without having inflation spiraling out of control. The velocity of money is falling and banks are simply sitting on the money.

You may have heard some complaints that banks are not lending, but if they did inflation would be running ramped by now. As long as the velocity of money is falling central banks will get away with printing large amounts of money. But the second the velocity of money picks up we will quickly be hit with a shock of inflation.

What is next inflation or deflation?

As we speak, governments around the world are quickly approaching their ability to borrow money at low rates. Greece was the first country to hit the wall, Spain, Italy, Ireland, and Portugal will be next. Perhaps even France and some others will face the same fate. There is a good chance that Japan will follow. Even the US will run up against the wall if we fail to deal with our deficit. Without access to easy credit spending will be curtailed. You can see this playing out in Europe and it is highly deflationary.

On the other hand, we better count on the fed stepping in with spending programs and outright monetization of debt at any sign of a slowdown. The fed has already proven that it is willing and able to purchase US treasuries, should the appetite for US bonds wane. This is inflationary but it does not instantly lead to a shock in inflation. Higher inflation only comes after an increase in the velocity of money. This process takes time and might disappoint many inflation hawks and gold bugs. We are talking years not months.

How to invest in this uncertain environment?

The battle between inflation and deflation makes a choppy market. Stocks are going sideways and commodities and risky assets are experiencing short booms followed by busts. But even a difficult market can present many opportunities.

Gold has typically done well both during deflation and inflation and this time is no exception. It may have been flat for the last couple of months but it has been up year over year for the past 11 years. It showed resilience during the crisis of 2008 and it has been the favored medium to store wealth throughout history.

In addition, money printing by central banks is likely to create new bubbles. The newly created money does not flow evenly throughout the economy. It tends to go into specific sectors of the economy â creating booms and busts. It may be difficult to tell with any certainly where the next bubble will be created but there is a pretty good chance that gold will become a bubble at some point in time. But before this happens inflation will be running ramped and the public sentiment towards gold will have to change. In the meantime any prudent investor may want to consider holding some gold and some cash and be on the lookout for the next opportunity.

To learn about trends and spot the next investment opportunity read the Casey Report from Casey Research. It's a monthly investment news letter that breakdown economic trends in a way that is easy to understand. They make recommendations based on economic reality and their track record is several times better than the market or any mutual fund for that matter.