Inflation or Deflation: Yes

Anyone who has an interest in finance should subscribe to John Mauldin’s bi-weekly newsletter. From domestic business activity to Europe’s debt crisis to sector specific news, his information is timely, relevant and always contains citations, usually from industry leading economists and money managers. In one of his last newsletters, Mr. Mauldin mentioned that when being asked about if the economy will experience inflation or deflation, his “ready answer is, ‘Yes.’” We wanted to take some time to explorer that idea this week.

Many investors believe that inflation is simply printing money. However inflation is actually a resulting price increase for goods or services due to a currency losing value. Deflation is just the opposite, where prices drop due to a currency suddenly strengthening. Inflation and deflation can occur when the relationship between economic growth (GDP) and money supply become out of whack.

Contrary to what many people believe, printing money is perfectly ok…if we as a nation have the economic growth to substantiate it. If the economy expands by 5% and money supply does not grow at all, it makes our currency much more valuable since there is a relatively smaller amount than there was before that economic growth. This is our main problem with the Gold Standard…while it can be good to have a commodity backing a currency, it limits the amount that the government increase the money supply by. When we are in the situation we currently find ourselves in with a massive national debt, the Gold Standard seems like a great idea. However on the flip side, when the economy expands and we do not increase the money supply, goods that were produced for a hypothetical $10 will have to be sold for less than what it cost to produce them. This could spell disaster for an economy that is trying to recover. It is also important to note that between the late 1800’s and the early 1900’s while the US was on the Gold Standard, we experienced a depression approximately once every 7 years.

Relating specifically to the US, Mr. Mauldin asserted, and we agree, that we will see both inflation and deflation over time. At what rates we cannot be certain. As we have mentioned before, two factors must be present for inflation to exist; volume and velocity. Following the Quantitative Easing policies of the FED in the last decade, there is plenty of volume, but there is no velocity. Velocity occurs when money turns over in the economy. For example, if you were to have $1000 on deposit with Bank of America, and they were hypothetically only required to have 10% of that deposit on hand, they could loan out $900. The money has turned over by one depositor essentially becoming the creditor to a borrower while the bank profits. When banks begin to loan funds to consumers and small businesses, we will absolutely see inflation.

We will likely not begin to see new loans until borrowers are certain that interest rates have bottomed, and that will not happen until interest rates begin to rise. Nobody wants to catch a falling knife, but when borrows can see a tangible bottom for rates, they will want to secure a loan as cheap as possible.

We believe that inflation will not occur before a bout with deflation. We are already seeing positive economic news all over; auto sales are increasing, manufacturing is increasing, companies are looking to hire, residential housing is beginning to sell again and new developments are going up all over the nation. What will truly spark some real economic growth in this country will be a sharp decline in gas prices once we begin to tap in to our four big domestic oil and natural gas reserves; the Bakken Formation, the Green River Formation, The Utica Shale and the Marcellus Shale.

Most Americans do not have the option to pay or not pay for oil based energy. Between home heating and fueling automobiles, this money must be spent and takes away from their ability to purchase consumer goods. Going after our domestic oil will create jobs in the refining and transportation industry, but will also stimulate the manufacturing industry. If a manufacturer’s costs are lower, they can justify hiring more employees considering the new increase in demand as well.

There is no doubt in our minds or in the minds of many well respected economists that energy prices are holding back domestic economic growth, so as soon as we can bring those prices down the economy will surely expand. The FED will have a difficult task in the future trying to keep the inflation rate relatively similar to GDP growth in order to avoid high deflation or inflation.

As Mr. Mauldin put it best, will there be inflation or deflation? Yes. Make sure that you are positioned accordingly or else your portfolio may suffer the consequences.

Ben Treece is a partner with Treece Investment Advisory Corp (www.TreeceInvestments.com) and licensed with FINRA (www.Finra.org) through Treece Financial Services Corp. The above information is the opinion of Ben Treece and should not be construed as investment advice or used without outside verification.
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