Hyperinflation or Deflation?

At present, the investment community is divided as to whether the world
economy faces hyperinflation or deflation. Some observers are convinced
that the central banks' printing press will take the world towards
hyperinflation whereas others believe that the ongoing contraction in
American private-sector debt will result in outright deflation. So, what will
the future bring?
 
It is my contention that we will get neither hyperinflation nor deflation.
 
What is more likely is that over the coming months, we will get another
deflationary scare. Any sell-off in the markets later this year will be met by
an even larger stimulus from the policymakers and this will ultimately result
in high inflation.
 
So, I maintain my view that due to the unprecedented policy responses
around the globe, the world's economy will face high inflation over the
medium to long-term. And the general price level will double over the
coming decade.
 
In the near-term however, we will probably get another period when the
market will (once again) become concerned about the prospects of a lengthy
economic contraction. It is conceivable that the 'green shoots' hype
currently doing the rounds will soon be replaced by more economic
worries as a second wave of foreclosures hits America later this year.
So, it is possible that before year-end, we will witness large corrections in
stocks and commodities. Conversely, we are likely to see big rallies in U.S.
government bonds, U.S. Dollar and Japanese Yen.
 
This near-term vulnerability in the markets is the reason why I have recently
liquidated my 'long' positions in resources and emerging markets and
gained a heavy exposure to long dated U.S. Treasuries. In my view, a
defensive investment stance is prudent at this juncture, as it will protect our
capital and allow profit from the expected contraction. Once the pullback in
the markets is complete, I will liquidate my positions in U.S. Treasuries and
re-invest our capital in our preferred holdings in energy, materials, mining
and emerging Asia.
 
Look. In the business of investing, the tape never lies and it is worth
remembering that Wall Street is littered with the graves of those who got
married to one particular outcome and then held on to their ill-conceived
notions. At this point, when private-sector debt contraction in America is
locking horns with central bank inflation, I prefer to have an open mind.
Therefore, I am maintaining a defensive near-term investment position. If
the market corrects over the following weeks, I will be in a position to profit
from such a decline. On the other hand, if the major indices simply
consolidate here and break above the recovery highs recorded last month,
then I will have no hesitation in changing my defensive investment position.
Put simply, I am currently watching and waiting patiently for the
market to reveal its hand.

Coming back to the subject of this essay, the reason that I don't foresee
immediate hyperinflation is because the velocity of money is currently
weak. In other words, at least for the moment, the private sector in America
isn't participating in Mr. Bernanke's inflation agenda. Despite the fact that
Mr. Bernanke has injected a massive amount of reserves in the banking
sector, this money is currently sitting as excess reserves within the
American banking system. The fact that this money isn't being lent out rules
out immediate hyperinflation. However, once the American economy
stabilizes and the velocity of money picks up, these excess reserves will
trigger a massive inflationary wave.
 
As far as deflation is concerned, I am of the view that the policy responses
and our fiat-money system will ensure that the purchasing power of
cash will continue to diminish over the medium to long-term. In fact, I
am willing to bet that cash will probably be the worst performing 'asset'
over the coming decade. Remember, in today's monetary system, central
banks and governments the world over are free to create money out of thin
air and this will prevent outright deflation in the global economy.
 
It is worth noting that in the past six months alone, China's commercial
bank credit has expanded by a whopping US$1 trillion! Figure 1 highlights
the surge in Chinese bank lending. Furthermore, credit is also expanding
frantically in other Asian nations. So, contrary to the West, monetary policy
is still alive and well in the developing nations and this factor also rules out
outright deflation in the global economy.
 
Figure 1: Explosion in China's bank credit
 

 
Source: Bank of China
 
In my opinion, rather than hyperinflation or outright deflation, we will
witness elevated inflation after the American economy has stabilized. In the
interim however, investors should be prepared for another deflationary scare
and the associated market panic.