Inflation/Deflation Uncertainty

Our government continues to CRUSH the value of the dollar so I asked Adam Katz from PlusEV.ca to break down the current situation. I've read the article and it provides a great view of what's going on, how we got here, and the nuts and blots (his words not mine). So please enjoy the article and COMMENT as Adam Katz and I are looking forward to your thoughts!

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I have received many emails over the past few months proclaiming that inflation is an obvious result of the current government intervention and that the dollar's days are numbered. As a nuts and bolts kinda guy, I like to step back and analyze the situation from point A to B, instead of staring at fancy charts which can usually be used to prove just about anything.

Before I get into the discussion, let me say that the focus of this article is timing more so than theory. To argue that we will never see inflation after the tricks central bankers have been pulling would simply make no sense. Yet, I was surprised last year to see some really good traders position themselves for an inflation trade in the middle of serious disinflation. After all, what the Fed was doing MUST have been inflationary! Right?

Firstly, what are the ingredients for credit expansion?

1)    Central banks expanding the money supply
2)    Banks lending that money out
3)    Credit worthy borrowers

Now we all know that we can place a big fat check mark next to (1), but what about the other ingredients? Putting money into the banks is easy; getting it into circulation is hard in a ‘fairly’ transparent system. Consider for a moment Zimbabwe, a country that has suffered unimaginable inflation. Do you think Robert Mugabe is subtle about expanding the money supply? He has the luxury of simply handing out money to his cronies and directly flooding the money supply. In countries like the U.S., such actions would be very difficult. China on the other hand can simply make large loans to government held businesses and thus expand the money supply.

The U.S. has been creative. For example, the AIG bailout after the Lehman collapse resulted in a transfer of government funds from AIG to large investment banks in the form of margin calls. When AIG’s credit rating was downgraded, they were forced to post margin with their counterparties. Yes this saved AIG, but it also saved those banks that were using AIG to hedge their risky trades with CDS contracts. The capital found its way into the banks, but never made it any further.

Now people are complaining. The stupid banks that made stupid loans have been bailed out. So why aren’t they lending? Why aren’t they making loans to borrowers who are not credit worthy? I hope my sarcasm wasn’t missed. To encourage banks to make bad loans is the most irresponsible thing that we can do. The point of the bailouts was to prevent financial collapse, not to continue the fundamentally flawed system.

Now we are seeing the economic follow through effects of both a credit and a housing bubble bursting. What is likely is that the credit worthiness of borrowers decreases and so will the banks willingness to make loans. Money won’t flood the markets – in the developed countries.
In the emerging markets, currency devaluation and sovereign defaults are alive and well. In fact, even Switzerland, the icon of monetary responsibility has engaged in devaluing their currency. If that’s not symbolic of the end of an era then I don’t know what is. My point is that the U.S. will continue to be a safe haven. As long as threats of further economic downside looms, the U.S. will continue to be perceived as the safest option – on a relative scale. Inflation will strike emerging markets long before it hits the U.S.

And when that happens, the U.S will be able to afford to allow their currency to weaken on an absolute basis because on a relative basis it will appear stronger than many of it’s peers. When risk appetite picks up, as it has done the past few days, the dollar will weaken. In the future, that pattern will coincide with the banks making more loans, and inflation will become a threat. However, that’s unlikely to happen any time soon, at least according to Meredith Whitney. She estimates that banks will cut $2.0 trillion of credit-card lines in 2009 and a total of $2.7 trillion will be cut by the end of 2010. That doesn’t bode well for inflation advocates, at least in the short term. This gives the Fed more than enough time to shrink the amount of funds that they have made available to banks and calls into question further asset price deflation over the coming 18 months.

I will leave you with the following basic economic concept: It is unexpected inflation, not expected inflation that causes havoc in the economy. With the current outlook of low or negative inflation for years to come, a sudden shift to high inflation would be devastating for the economy.

Adam Katz
www.PlusEV.ca