Inflation or Deflation… Which is worse?

I read an interesting article back in May which addressed the question,

“How do you guard against both the deflationary forces of America’s worst recession since the 1930′s and the vigorous response of the Federal Reserve, which has in effect cut interest rates to zero and rapidly expanded its balance-sheet? 

A reknown Fed historian, Allan Meltzer foresees a repeat of 1970′s inflation, and a Nobel laureate in economics, Paul Krugman gave a warning that Japan-style deflation was immenent.  I guess what it comes down to is that neither one is actually GOOD, but inflation or hyper-inflation as some predict is in the future and at least we can control mitigating factors.  Most predictions of inflation have prices going up by mid 2010.

For the first time since 1955, the U.S has had  a decline in American consumer prices.  Although the decline was 0.4%, most of it is the effect of falling energy prices.  The core inflation is 1.8%, which excludes food and energy.  The most concerning indicator are consistent price delines.  With unemployment high, the economic output is way below the economy’s actual potential than at any time since 1982.  Unfortunatly, the gap is going to widen.  Although home prices are not part of our inflation index, the decline is forcing homeowners/households to reduce debt, thus creates less spending.  The concern is that this could be the anchor on the economic growth for as some say, years.  We can expect additional negative price pressure as workers viciously compete for jobs and companies try to out-bid one another.

Deflation, is far worse than inflation, and the American people also tend to agree, however with rising pay freezes and increasing unemployment, you may want to think again.  It’s kind of a catch 22 situation we are in.  If inflation comes as expected, which would help the U.S currency and do all the good things our government wants it to, we will continue to be stuck in this recession rut since consumer spending will come down and negate the much needed market productivity.  Real debt is a weight on a consumers’ shoulders, which cause  further cutbacks to service their debt or they go the other route and default on their debt, a severe undermine to the financial system which will deepen the recession.

So again, I ask, is deflation or inflation worse?  Inflation is easier to curb than deflation.  One could argue that the Fed will be unable / unwilling to reverse deflation in time to prevent climbing inflation.  How is inflation easier to control?  A central bank can raise interest rates as high as they want to in order to mitigate inflation, but you can only go as far down as 0% on interest rates.  There is no negative interest.  If there is, I want it!  Deflation makes it tough for a central bank to stimulate consumer spending.  At worse, rising defaults and debt anchor positive growth, poisoning our economy by futher deflation and pushing higher interest rates. 

As most think of inflation, rising interest rates, etc., I believe that the Fed will feel political pressure to not  increase beyond what is considered “enough”, as they make a case for not harming the financial markets. 

So I leave you with a concluding thought from my buddy Noah Rosenblatt of UrbanDigs. 

With deflation the US dollar should swell. This is what happened during the course of 2008 which since has been negated some by inflationary policies and a rush out of dollars to higher yielding asset classes; doesn’t mean we have an inflation problem now though. The net move in the US dollar was muted because of deflationary forces and the rise that our currency saw when the crisis reached its zenith.

Already we are hearing talk of possible exit strategies by our fed to limit any whiplash inflation resulting from the extreme policies put into place to stem this crisis. The most recent is the potential for tighter capital requirements for our banks – Greenspan on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said banks should be forced to hold more capital on their balance sheets, reinforcing a weekend push by finance chiefs from the Group of 20 nations. 

 

I listed this as #4 in exit strategies to expect in 2010 & 2011, as the fed reins in emergency lending facilities. The process of writing off bad loans/securities and debt-restructuring will continue until consumers and businesses can sustainably maintain debt service payments. When the debts are written down to where they should be, we can start to discuss future sustainable credit growth. Until this process plays out the fed is likely to maintain stimulative inflationary policies. In the end, banks need sound consumers & businesses to lend to and that is the deflationary process that is ongoing today.

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