Could we have deflation AND inflation??

disclaimer: the following is more logic exercise than economic analysis...


Moot Debate - Misses the Big Picture

Most frequently, the debate around inflation revolves around the all-encompassing metric known as CPI (consumer price index).  Today's pundits debate endlessly about the future trajectory of the CPI.  However, perhaps speculating what the CPI will be in totality may be missing some important scenarios...

Let us divide goods into two categories and discuss the inflation outlook for each category separately...

The Humble Goods

First, let's talk about the essential commodity goods.  Primarily I am thinking of such items as wheat, grain, milk, orange juice, coffee, oil, water, corn, sugar, etc.  These are items that most people need to survive, and that are not produced in factories, but must be grown on agricultural land (whether directly or implicity, ie cows eating grass and then producing milk).

My (unsupported) conjecture is that these goods did not suffer the gluttony of overinvestment/overcapacity during the boom-period.  Logically speaking, most people with reasonable living standards do not eat significantly more wheat during boom periods than what's needed to keep them alive.  Hence, there's little reason to believe that we developed significantly more farms during the boom period than we needed.  Furthermore, most people, with the means to, will continue consuming wheat at a stable pace (sustenance).  In fact, global population trends suggest that demand for such commodity goods will continue to increase as populations increase (more grain/wheat) and living standards rise (sugar/milk).

Based upon this line of reasoning, it seems plausible to suggest that such essential commodities are unlikely to experience sustained, long-term price declines.  What about price inflation?  As central banks around the world work to fight deflation (as measured by simple metrics such as CPI), they will likely increase the monetary base, thereby potentially fueling price inflation in these humbler goods.

Other commodities, such as metals, are more ambiguous.  The problem is that steel, concrete, etc are tied to the 2nd group of goods/services more so than wheat/grain.  Though we may experience price inflation in food, prices of wood may not increase, because we don't necessarily need more wood to build more houses... more detailed discussion below.


Gold/Silver are unique metals though, since they're value is derived not from industrial use...


The Luxury Goods

It's difficult to exactly define what goods (services) fall in which category, so I'll give some more examples of the type of items I am referring to here:  TV's, consumer electronics, housing, auto, mall retailers, casual dining restaurants, computers, and all the various sub-industries that feed off/into the aforementioned.  In general, anything that people don't need to directly eat (to survive).

In my opinion, during the boom-years we either produced too many luxury goods (homes) or overinvested in the capacity to produce such goods (ie factories, workers).  The extra money that people had which they did not use to buy more wheat was used to buy LCD TV's, ipods, and a nice meal at Applebees.  With the decrease in disposable income, consumers will shun these items as they attempt to rebuild household balance sheets, and prepare to retire significantly later than they had originally hoped/anticipated.  These are powerful market forces, and will likely lead to irresistible deflationary pressures.

However, as said before, central banks (and political institutions) need to prevent deflation - economically because of the deathly fear of deflationary spiral, and politically because most export industries (except may Canada, Australia, South Africa, Middle East) rely primarily on luxury goods.  They will likely summon a variety of tools to their cause, with the likely outcome of increasing the monetary base.  In the aftermath, their policies may very well stop price deflation in these luxury goods, but not without significant price inflation in the humbler goods.

Ramifications

These are too numerous to recount.  However, most likely this policy bodes ill for middle-class and lower-class families.  With less to spend already due to the recession (depression), they will be devoting a greater portion of their wages to essential goods.  With increased price inflation on bread, rice, and water, these families will likely feel further disenfranchised by policy makers, as they find themselves trapped between the proverbial rock and hard place.

In addition, CPI may very well remain flat, or increase moderately for a period.  While policy makers cheer the success of their experimentation (make no mistake, that is what it is...), the villagers will be sharpening their pitchforks and pouring kerosene on their torches, as they find themselves struggling more and more just to put food in their mouths...

Though we are few, I am not alone...

Jim Rogers is a big bull for commodities (although he is bullish on metals & industrial commodities too because of China), Michael Burry has also come on record as saying that he is buying 'productive agricultural land with water on site'...

Maybe it's time to buy a tract of land, plant some corn, and learn the banjo...?

Disclaimer - the below graph has cherry-picked data to illustrate my point... I don't believe that the longer-term past is as representative of the near/medium future...

Deflation or Inflation - Guide to Picking Poisons

America's Greatest Fear - Deflation

Deflation is a decline in the price level of goods and services.  Generally, we cheer when the price of goods (groceries, gas, cars) decline.  As for policy makers, they fear deflation as if it was the great plague.  In fact, no country champions the cause against deflation more strongly than the U.S.

To understand the paradigm of America's decision makers, we must turn to a lesson in history.  The worst recession in recent memory, the Great Depression of the 1930's, was a deflationary period.  During such episodes, the economy could experience deflationary spirals, whereby declining prices induce the expectation of ever-lower prices in the future, hence creating a feedback-loop which results in uncontrolled price declines.

In addition, policy makers may run into what is known as a liquidity trap, whereby their traditional tools of monetary policy become exhausted.  This exact problem was addressed by current Fed Chairman Ben Bernanke, in the now famous speech Deflation: Making Sure "It" Doesn't Happen Here.  Chairman Bernanke reassured congress that through the 'helicopter drop' of money, the Fed would be able to successfully combat deflation.  With regard to this assertion, I am inclined to agree with Chairman Bernanke; I am also deeply concerned about the potential ramifications of such reckless monetary policy.  My fears are echoed by our neighbors across the Atlantic.


Germany's Worst Nightmare - Inflation

Just as America's paradigms were influenced by its history, so too were those of the German people.  Though the inflation in the Weimar Republic, post WWI Germany, was nearly 100 years ago, the people have not forgotten the horror:

Inflation is an increase in the general price level of goods and services.  Hyper-inflation is the runaway effects of such a price increase.  From the years 1918 to 1923, what used to cost 1 Mark increased in price, until the same good could not be purchased for less than 1 Trillion Marks.  To personalize this increase, imagine a 1 liter bottle of Coke costing approximately $1,000,000,000,000 dollars.  It sounds ridiculous, but sadly, it was a part of German history (Germans were not alone in this... hyperinflation dates back to as far as the time of the Romans... likely since the invention of money itself ).

All I'm saying is...

I believe our policy makers are influenced greatly by the events of the country's history.  To that extent, the strong aversion to deflationary periods is understandable.

However, the lack of respect for counterbalancing forces could force us to learn some harsh lessons in the near future.  Perhaps we should turn to our German neighbors to strike a more balanced view.