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Is it Deflation yet, or is Hyperinflation on the way?

Economics / Inflation Jan 20, 2009 - 02:04 PM GMT

By: Joseph_Toronto

Economics Best Financial Markets Analysis ArticleLet's take a short detour to make sure we understand what inflation and deflation are. Milton Friedman, the father of the monetarist school of economics said that inflation is always and everywhere a monetary phenomenon. This is usually explained to the layman as “too much money chasing too few goods.”


Inflation is generally regarded as a rise in the price level of goods and services in the economy. The term also refers to increases in the money supply. Inflation can also be described as a decline in the real value of money—a loss of purchasing power in money. In these circumstances, consumers have an aversion to holding cash without earning interest equal to or greater than the loss of purchasing power. Hyper-inflation is the result of a total loss of confidence in the money in circulation and no one will hold the currency for any length of time for any reason. The velocity factor of money explodes the money in circulation and prices skyrocket.

Deflation on the other hand is a condition correlated to a shrinking money supply which if it persists induces consumers to hoard cash and cease expenditures altogether because they have a sure expectation that prices will soon be lower. When one hoards cash, whether in a mattress or in a bank account, the money in circulation collapses, prices fall, and people hoard more cash as it's scarcity value continues to increase it's purchasing power.

You should be able to see that inflation and deflation are not necessarily monetary phenomena only, but can be caused and exacerbated by human expectations. Milton Friedman's statement is relevant only when employing economists favorite escape clause, “all other things being equal” including the assumption of static human expectations.

Economist Gerard Jackson explains deflation this way: http://www.brookesnews.com/091901obamarecession.html

“Deflation occurs where the absolute quantity of money shrinks. This invariably happened when there was a run on the banks. When depositors withdrew their money a reverse multiplier set in and a rapid monetary contraction occurred bringing a recession in tow. The result was that prices had to fall if the number of transactions was not to fall. Of course, true deflations are always accompanied by depressions because what is contracting is not notes or coins, i.e., cash, but fictitious bank deposits, the product of credit expansion produced by a fractional reserve banking system. This is where we get our reverse multiplier.

There is no doubt that the money supply is collapsing ( http://joesinvestoblog.com/?p=292) as money evaporates with each and every defaulting mortgage, bad loan and bank loss. The rapidity and ferocity of the collapse together with the futility of the Fed's massive new lending programs, lends one to believe that we are facing a liquidity trap tantamount to the Fed's “pushing on a string”. A liquidity trap occurs when even though interest rates have fallen to zero, economic uncertainty and fear of default is so high among lenders and borrowers, that no one can be induced to lend or borrow in order to reflate the money supply. This is evident in the Fed's expansion of the monetary base by nearly a TRILLION dollars which did little more than expand bank reserves by an equal amount. It tells us that none of the Fed's new money is being lent out. It's sitting in bank's reserve accounts.

So where are we now?

Are we to experience Depression era deflation for the first time in a century or will the soon to be enacted governmental fiscal stimulus together with the central banks attempts to massively reflate the money supply result in hyper-inflation?

It appears that in this circumstance where even though commodity prices are rapidly falling and consumer prices are dipping not quite so dramatically, that deflation is a risk. We have no way of knowing whether this is becoming entrenched in expectations which have previously been drenched in decades of inflation. What we do know is that the Fed will do everything in its power to avert deflation. Why? Because the proverbial liquidity trap renders the Fed's powerful monetary policy levers utterly ineffective and obsolete, just as in the Great Depression whereby economic growth declined or stagnated for over a decade despite the best efforts of the Fed. Deflation reduces the all powerful central bank to a mere bystander in an economic catastrophe.

If the lending and borrowing tide ever turns, and it will, the Fed will be faced with the unenviable task of mopping up all of that excess cash before hyperinflation sets in. They will be forced to sell all of those assets and bonds they have been massively buying forcing interest rates substantially higher thereby running the risk of truncating an incipient economic recovery. It's quite a tightrope they will have to walk if successful in averting deflation. Recent and ancient history of central banking effectiveness in managing the money supply under sometimes erratic human behavior and expectations indicates that although the Fed may eventually be successful, or not, it will be very very messy getting there

Very Best Regards,

Joseph Toronto

http://joesinvestoblog.com

Joseph Toronto, has managed stock and bond portfolios for 26 years for some of the largest institutions in the west. He began in 1982 as a portfolio manager and analyst for the LDS Church Investment Trusts. In moving to the Trust Division of West One Bank he became senior investment officer and managed assets in excess of $100 million. Later, as the senior portfolio manager of Pacific American Investors, Inc. he managed stock and bond portfolios for high net-worth individuals nationwide. In 1993, Mr. Toronto founded Affiliated Investment Advisors, Inc., as a registered investment advisor for serious investors seeking professional management for superior safety and returns. Mr. Toronto is a Chartered Financial Analyst and is a member of the Salt Lake City Chapter of the Financial Analysts Society and the Association for Investment Management and Research. He has a Master's degree in investment securities and a B.A. degree with a dual major in finance and management.

Currently, Affiliated Investment Advisors, Inc. manages investment portfolios for retirement plans, profit sharing plans, individuals, IRA's and other trusts.  We believe Affiliated offers professional portfolio management with superior investment returns while steadfastly safeguarding and protecting your capital. As a registered Investment Advisor, Affiliated's portfolio management services are “fee only” and takes no commissions or performance incentive.  It is not a stock broker or financial planner and does not sell any investment or insurance fund or product. joe@aiadvisors.com

© 2009 Copyright Joseph Toronto - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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