No Signs of Deflation

The 1st quarter is coming to a close today with some interesting results. The Dow is up 6.6%, oil is up 17%, and gold (the ultimate  “bubble”) is up 2%. As you can see, these are some truly explosive moves in gold relative to other assets, so the popping of the bubble must be near! All kidding aside, these asset movements clearly indicate that an inflationary trend is upon us.

I have been looking for higher levels of inflation for a long time. Deflationists who have been predicting a debt-deflation price spiral have been completely wrong. It truly amazes me that people think a sustained deflationary trend is possible when the dollar is not linked to gold anymore. As many dollars as needed will be printed to keep the economy above water. The Fed will support asset prices at the expense of the dollar. We will default on our debts via inflation. Case in point, the dollar is down 4% this quarter. Where are the deflationists who predicted new highs in the dollar? If the dollar can’t make new highs when it is the “safe haven” currency, when can it?

Domestically Focused Deflation Theories

The flaw with many theories of deflation is that they are too domestically focused. Some economists believe inflation is inversely correlated with unemployment. Ok. So why aren’t high levels of domestic unemployment stopping crude oil from hitting 3-year highs? What if there is civil unrest in the middle east? What if demand for crude oil outside the U.S. rises? Will these events not drive crude oil higher irrespective of domestic unemployment? Now let’s think of exchange rates. If countries sold their dollar holdings, thereby weakening the dollar’s exchange rate, this would create inflationary forces in the U.S. regardless of the domestic unemployment situation. There are so many variables that affect inflation besides the domestic unemployment rate or industrial slack. These are simply theories that assume the United States is the only economy in the world and that the free-floating system does not exist.

The interesting thing about this cycle of inflation is that not all asset classes will necessarily benefit. Stocks and commodities are clear winners so far. Interestingly though, real estate- the best inflation hedge of them all- is not following suit. This has to do with its relative illiquidity, rising property taxes, and the extent to which housing was a bubble in America. For those who are long-term bullish on real estate, I would like to remind you that housing in Japan is still deflating after 20 years of contraction. Downward housing cycles can and do last decades.

The real problems in our economy will arise when all asset classes, including real estate, are rising. At first, such a trend will be welcomed due to the temporary relief it will bring for homeowners. However, rising asset values will undoubtedly come at the dollar’s expense. Treasuries become less attractive investment vehicles when the dollar is falling. If there is no bid on our debt, then what? The costs of running government are set to rise dramatically in the years ahead. This is a situation we are definitely not prepared for.

No Signs of Deflation is a post from: Expected Returns

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