Choose Your Pain

Why We're Facing Deflation - John Mauldin

I wrote in 2003 -- when Greenspan was holding down rates too long in order to spur the economy -- that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that’s the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there’s a cost.

It’s not a matter of pain or no pain; it’s a matter of choosing which pain we’ll face, for how long, and perhaps, in what order. As I wrote a few weeks ago, like teenagers, we as an economic polity have made some very bad choices. We’re now in a scenario where there are no good choices, just less-bad ones.

That really sums up my thinking on the matter.

I turned bearish in August of 2004. Since then we've seen inflation rise as oil rose (to $140+) and we've seen inflation fall (as prices collapsed due to the credit crisis). So let's see what inflation has averaged since I turned bearish. That's something I've never actually checked.

In August of 2004, the seasonally adjusted CPI was 189.2.
In July of 2009, the seasonally adjusted CPI was 214.469.

That's a 13.4% increase over 4 11/12ths years. That's a 2.6% rate over pretty much the entire full cycle. That's assuming that today's conditions somewhat mirror those in 2004. I think they do to some degree. By 2004, the stock market had risen well off its low. We were also told that the economy had recovered from the dotcom disaster.

Maybe 2.6% inflation is all we end up getting over the next full cycle. In any event, history has shown that a relatively tame average inflation rate of 2.6% can still inflict pain in large quantities.

If I could know for sure that inflation would average 2.6% going forward, then I'd be even more comfortable than I am now by simply riding it out in Treasury Inflation Protected Securities (TIPS).

I can't quite put my finger on why but deep down that must be what I think. I can't get excited enough about deflation to drop the inflation protection that TIPS offer. I also can't get excited enough about inflation to borrow vast amounts of money to overleverage myself chasing hot commodities. About the only thing that seems to remain a constant is my desire to protect my nest egg. Perhaps it has something to do with the legendary nature of this "new" economy's ability to eat up nest eggs and spit them out.

This is not investment advice.