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Inflation, Deflation, or Stagflation?

Posted by Larry Doyle on June 1, 2009 11:06 AM |

I am an eternal optimist and, as such, I never want to see people’s spirits waver. I encourage people not to allow the current economy to “deflate” their hopes for better days. By the same token, I am a pragmatist and caution people not to view the recent bounce in our equity markets as reason for an overly “inflated” sense of optimism. In this same spirit, though, we need sufficient optimism along with practical analysis to avoid the perils of “stagflation.” Let me expound.

The debate between analysts touting prospects for inflation versus deflation is ongoing. Those concerned with deflation highlight increasing levels of unemployment pressuring wages, falling asset valuations, and slack consumer demand. Those concerned with inflation point toward the unprecedented levels of liquidity injected into our system via all of the government programs. The inflation hawks maintain the economy merely needs a small spark and inflation will spread in an uncontrollable arson-like fashion.

I actually believe there is a very real chance we get developments from both camps leading to the scourge known as stagflation. How may this play out?

Many respected analysts are promoting the concept of a new “normal” economy. This scenario entails an economy operating with enormous government deficits, an elevated level of unemployment, and little to no shadow banking system (securitization of loans and other assets).

In this new “normal” economy, GDP may only eke out small positive growth given these heightened pressures. Pimco’s Mohamed El-Erian writes of A New Normal:

This reflects a growing realization that some of the recent abrupt changes to markets, households, institutions, and government policies are unlikely to be reversed in the next few years. Global growth will be subdued for a while and unemployment high; a heavy hand of government will be evident in several sectors; the core of the global system will be less cohesive and, with the magnet of the Anglo-Saxon model in retreat, finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time toward higher sovereign risk, growing inflationary expectations and stagflation.

Even as we come out of this recession, our economy will run increased risks of slipping into another recession given the lack of cushion provided by a strong consumer, the burdens of heavy government debts, and inability to easily access credit.

El-Erian adds:

For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector. (As one of our speakers put it, we have transitioned from a world where the private sector provided public goods to one where the public sector provides private goods.) It is also a world in which central banks and treasuries will find it difficult to undo smoothly some of the recent emergency steps. This is particularly consequential in countries, such as the U.K. and U.S., where many short-term policy imperatives materially conflict with medium-term ones.

As our global economy transitions to this new “normal,” I believe the likelihood of stagflation is quite high. For those who recall the perils of our economy in the early 1980s, stagflation is not a pretty picture. How does one manage investments and personal finances in an environment of stagflation?

Let’s deal with the component parts. Given sluggish growth, limited credit, and lessened opportunities, it is of paramount importance to cut expenses and minimize debt as much as possible. Servicing debt will be an ongoing challenge and increasingly problematic. Be proactive at this point in time in adjusting your finances to this reality.

Where will the inflation come from and how does one address it? In my opinion, the inflation “train” will arrive sooner than we think. Some of the savviest investors, including Financial Pacific Advisors’ Bob Rodriguez and noted Black Swan author Nassim Nicholas Taleb, are already positioning themselves for it. (The WSJ reports, Black Swan Fund Makes a Big Bet on Inflation).

How can people protect themselves from the inflation monster? Increase exposure to the following:

  – precious metals and commodities

  – critical infrastructure (power plants, agriculture, water, transportation)

  – necessary life items (drugs, medicines, food)

  – stronger and more fiscally prudent foreign markets

Decrease exposure if not get outright short

  – longer maturity (5yr and and longer) Treasury bonds

This stagflation story will have many chapters and I will be writing extensively on it. Please share your thoughts, opinions, and recollections of the early 80s economy so we can all move forward most effectively in navigating the economic landscape.

LD

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  • Petricone456

    What do you make of the strong rally in equity markets today in light of concurrent meltdown in Treasury prices? Last week equity traders couldn’t help but focus on what was going on in Treasuries. Are we setting up for a hard fall in equities sometime this week (perhaps on results of the 10 year or 30 year Treasury auction)?

  • kbdabear

    http://www.businessinsider.com/chart-of-the-day-deposit-insurance-fund-balance-2009-6

    FDIC is going broke according to the chart. The Big Boys are supposedly “safe” but the smaller banks are still dropping at a high rate. Larry has touched on this and it’s been under the MSM radar.

  • kbdabear

    I remember the late 70s and early 80s. There was a hat trick of double digit interest rates, unemployment, and inflation. The difference now is that the media didn’t coddle Jimmy Carter and certainly not Ronald Reagan, when we reach and surpass those days, the MSM will still hail Obama as a brilliant economic mind. ABBA is played on the radio a lot, so watch out for disco and leisure suits. If only the original cast of SNL could come back and we could at least laugh at “Airplane III”






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