I had the opportunity recently to exchange emails with one of the more grounded economists around. He is a regular on business television, and one of the few who saw the problems of the past decade coming. Currently, he also happens to fall in the camp of the disinflationists/deflationists.
My question to him was why (for so many), inflation implies economic growth, while deflation need imply slowdown. (Actually, I think I know the answer to the second half of the query, but more I was curious why inflation must mean more robust recovery.) The answer I got was that it's hard to raise prices when demand is weak and running below aggregate supply. Pretty straightforward. Add to that, it seems that most people rely on CPI as the basis for determining whether inflation exists. CPI is running very low these days (and the economy just so happened to hit a few speed bumps lately, calling into question the recovery that gets touted all the time). Case closed, I guess.
But, as others have aptly and eloquently pointed out before, CPI is a massively manipulated number. The two main problems: hedonics and the exclusion of food and energy prices from its calculation. A lot of folks, including the above-referenced economist (who I have tremendous respect for), see CPI as the canary in the coal mine. As long as it goes down, we should expect deflation generally, and lower treasury yields specifically.
Nevertheless, I operate with a different mind set. I think we could have inflation in the midst of a sputtering economy. I think interest rates are destined to rise (just don't ask me when exactly). And when they do, life for most average Americans will get that much tougher. If inflation is really about demand, couldn't we have a scenario where the price of food and energy go up painfully, since those are two key inputs of daily life that we can't go without (all while CPI happily continues along). I know people like to dismiss grocery store inflation like it's some sort of joke, but how isn't it relevant to the conversation? Still, getting past that point for a minute, my instinct is that the agonies of inflation won't be experienced simply at the corner deli.
I read a great interview recently with Terry Coxon (of Casey Research) in which he articulated a fundamental premise: increasing the money supply eventually leads to inflation. That's just the way it works. I guess it doesn't have to, but it's the inevitable consequence of relying on the Federal Reserve. (The next time they catch a bubble before it forms, it will be a first.) To expect them to know when to sop up liquidity is an exercise in futility. Practically, when you have irresponsible monetary (and fiscal) policy, the easy money that results is going to go somewhere. We already saw its impact on the real estate market, and before that how it effected the tech sector. We have an election coming up this Fall, and if you don't think the Fed (with a little tap on the shoulder and encouragement from Barry, Tim, Nancy, etc.) is going to accommodate, you're not paying attention. Money printing, QE2, whatever you want to call it, it's coming. And it will lead to more bubbles and bigger problems down the road.
And not to go off on a tangent, but what of gold? Isn't that a canary? If we are to believe that deflation is the trend, why is gold in the midst of a convincing secular bull market (one that everyone likes to dismiss as a bubble, by the way - I think that's called irony).
So, given that it's now become too late to tell this story quickly, here's where the rubber meets the road. I think that where we are seeing the most obvious inflation is in the US Treasury market (ahh, now I get the reference to Animal House). We are seeing a steady and increasing march towards the fixed income market, in particular to the promises of Uncle Sam. And like real estate, where cap rates became silly, treasury rates are headed towards numbers that cause a head scratch. And when the unwind comes, it won't be because the economy has gotten back on its feet, it will be because the U.S. is like every other country that has been irresponsible with its spending. In the end, buyers of its debt are going to demand to be compensated. And we'll be able to look around and enjoy 10%+ unemployment all at the same time.
And with that, who did I borrow this soap box from again...
