Earlier this year inflation was all the rage. Oil is up! Grains are up! Metals are up! Now, however, it's deflation that has investors and the Federal Reserve panicked. Oil is down! Grains are down! Metals are down! Which one should we be worried about—rising prices or falling prices—or at least preparing for? The answer may be surprising.
It's worth pointing out that both inflation and deflation can seem much more appealing than the dire headlines suggest. Yes, back in the early 1980s, during our last major bout with inflation, prices were soaring. We had nearly 15 percent inflation, which was driving up the cost of everything in sight, from wages to products and services. But there was a bright side (or two). Higher wages, at least temporarily, made people feel better; and interest rates touched the high teens, even 20 percent, which, in retrospect, seems like a delirium dream. If only we could lock in those sort of returns today, we think. Ah, inflation!
Panic is vastly underrated as a response, so feel free to start there.
The trouble is, we forget that higher interest rates must be put in context. While rates were high, they came at a time when people thought cash was trash, with inflation eating away 10 to 15 percent of the value of a dollar in any given year. Sticking your money in a bank account for a few years, even one earning high interest rates, seemed much more dangerous to people then than it might appear today from our yield-starved perspective.
The funny thing is, deflation has some of the same semi-romantic appeal. In that sort of economic period, prices are falling all around us: Wait a month, or a year, and whatever you want will cost less. Cash is king, etc. All you need to do is hoard money and tomorrow you'll be wealthy. Who needs high interest rates, or equities—just hide what you have from anything risky and tomorrow, or maybe the tomorrow after that, you'll be able to do something with it. What's to complain about?
Plenty. A collective compulsion to hoard money in the face of falling prices creates a dormant economy. The implicit buyers' strike causes all industries to see their revenues go pffffft, except for those delivering the few things that people must buy, like health care, food, and fuel. Deflation is a business and economy killer. Companies struggle to get by as consumers hide away and grow carrots. In the end, we re-enact the Depression.
Neither scenario leaves us much to choose from, and in some sense, it's not our choice anyway. We had inflation earlier this year, and have deflation now. Prices will fall in the current quarter, and will likely fall for at least a few quarters more, for the first time since the Depression.
Knowing the perils of deflation, officials are working to arrest this slide, and the massive Treasury/Federal Reserve cash transfusion into the US economy—more than $7 trillion, at last count—is, in large part, an attempt to do that. The government is trying to convince people that cash isn't king, that money will soon start flowing again, causing prices to stop sliding and thus requiring you to stop hoarding. (Now, we don't want people to stop saving entirely again. We want US savings rates to tick higher from their previously near-zero levels, perhaps to 6 percent or so. We just don't want no spending.)
But deflation is going to end before too long, so investors shouldn't get overly comfortable. There are a few reasons, including, perhaps paradoxically, that a little bit of inflation is good for the economy.
It keeps wages going up, which makes people feel better, and it convinces people to spend money, given that hoarding just means paying (a little) more for things later. At the same time, all this money sloshing around in new programs must eventually either go somewhere or be removed. While the Fed has said it will do this (it likes to use the word "sterilize") when this crisis is over, that will be far easier said than done. There will be massive amounts of rogue money in the system looking for a new home, and thereby driving prices higher.
Avoiding inflation after so much stimulus will be like avoiding acceleration after having pressed the gas pedal flat to the floor in a truck that has now swapped going uphill for going downhill.
As hard as it might be to imagine now, it seems entirely likely that a year or more from now we will be faced with soaring gas and food and commodity prices, and worrying how to get the inflationary genie back in the bottle. I know, I know, it sounds nuts, but trust me on this: We've already loaded the system with the necessary dollars to do the deed—the trick will become avoiding hyperinflation of the kind that kills currencies, as happened in the Weimar Republic.
What should investors do? Panic is vastly underrated as a response, so feel free to start there. Next up, look at some commodity-based exchange-traded funds, of which there are now many. You should also have some holdings in inflation-indexed government bonds, which, absent a government collapse, will provide some protection. Overall, however, you just need to know that we're about to do a three-step, from inflation (earlier this year), to deflation (now), and back to inflation again (a year or so from now). It's going to be neck-snapping.
Paul Kedrosky is the editor of Infectious Greed, one of the best-known business blogs. He's currently a senior fellow at the Kauffman Foundation, where he is focused on entrepreneurship, innovation, and the future of risk capital. He is also a strategist with Ten Asset Management, a Southern California institutional money management firm.