Inflation or deflation? The premise for inflation rests on the policy mix of large budget deficits and highly stimulative monetary policies. The Federal Reserve will do whatever it takes if U.S. growth slows to the point where unemployment rates start rising again. Democracies are prone to inflation because of the pressure to buy votes and the risks are especially high in a fiat money system. Never-the-less, deflation represents a greater threat over the next several years. Rising debt burdens have the potential to be inflationary, but at a certain level, a tipping point is reached, and excessive debt can become a deflationary force. Arguments against inflation include weak growth in money and credit, stagnant real incomes, high unemployment rates, and looming fiscal restraint. In the U.S., quantitative easing has so far prevented deflation, but the risk remains high in Europe.

A counterview is that a falling U.S. dollar creates a virtual inflation by making input cost and imported goods more expensive. And given Fed policies, the currency may fall further. A weak dollar has already been a factor behind rising commodity, input and import prices, and that has created some inflationary pressures. However, the other side of a weak dollar has been a strong euro and yen, which represents a problem for the indebted and struggling European and Japanese economies. The currently strong yen worsens deflationary pressures by depressing exports and decimating companies that would have otherwise survived. In Europe, Germany is enthusiastically embracing fiscal austerity at a time of softening world economic growth and a surge in private sector savings across the globe; the risk of a policy mistake is decisively skewed toward deflation.

The story of inflation is very different in the emerging world. In many of these economies: a) money growth has been excessive, b) there is stronger pass-through of higher oil and commodity prices, and c) wage pressures have been building. In addition, because food costs are a far greater percentage of personal income and the consumer prices in emerging countries then they are in the developed world, the rapid rise in agricultural and food prices has greatly increased inflation amongst the emerging economies. Thankfully, the monetary authorities have been responding with tighter policies, and this should keep inflation in check.

In summation, inflation is not a clear and present danger for the developed economies. However, this view stands in stark contrast to much of the media blitz and mainstream chatter. Current policy settings certainly have the potential to create inflation, but this potential will not be realized when the money and credit multiplier is so weak and when high unemployment keeps a cap on wage growth. Of course, there is a downside to the weakness of wage growth at a time when headline inflation has been pushed up by higher food and energy prices. The financial health of the average worker in the U.S. is not good: real living standards are under pressure, house prices continue to fall with about a quarter of mortgage holders in negative equity, and job security is scant. Therefore, although the headline consumer price index may signify an inflation problem, declining real incomes and house prices are more consistent with deflation. Turning to the other major developed regions, Japan has moved back into recession at a time when deflation is already entrenched, and fiscal austerity will exert deflationary pressures in many European economies. The countries with a history of public spending prolificacy (e.g., Greece, Spain, and Italy) are being punished, squeezed and severely trodden upon by the marketplace. As such, the European Central Bank’s plan to raise rates in July seems ill timed.

Michael Ashley Schulman, CFA
Managing Director
Hollencrest Capital Management
www.hollencrest.com