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Biflation
Since expanding on “the New Normal”, I have mentally struggled with the inflation/deflation conundrum. The best working hypothesis for the future is “biflation” which explains how inflation and deflation exist simultaneously. During biflation there is a rise in prices of commodity and earning-based assets and a contemporaneous fall in debt -based assets. The global environment is flooded by money created by central banks. As many goods and services are essential, there remains strong demand for commodity-based goods: food, drink, clothing, gold, energy and infrastructure. These goods attract high demand as there is too much money chasing them. Hence inflation. At the same time, there is massive unemployment in the West, a change in taste towards frugality in consumers, and signs of mounting fiscal austerity. Consumers are also squeezed by debt servicing. As other bills rise, and confidence erodes, high end debt-based assets such as expensive jewellery, houses, even shares, lose attraction. Their price deflates as demand weakens.
Biflation’s appealThe concept aligns well with my inherent belief of a commodity supercycle, and that investment in commodities such as energy, food, and gold and metals should be part of portfolios. The price of these has been increasing and no let-up is in sight.Moreover, it is difficult to project a coherent view of the outlook without biflation, the simultaneous existence of inflationary and deflationary forces. The alternative is to opt for one or the other, or perhaps suggest inflation phases will follow deflationary and then reverse. These alternatives are not cogent. As capitalism is a process of “creative destruction”, there is always growth and decay. In modern states, IT and mining capabilities are growing while some industries are phasing out. Sometimes whole districts like Silicon Valley or parts of Australia are in a long boom (which creates inflationary pressures), whilst other districts are part of a rust belt with deflationary tendencies. Biflation assists in understanding market dynamics.
DeflationDeflation has been a substantial part of the Japanese scene for a generation and it now appears that the US is vulnerable to the Japanese disease. Several members of the Federal Reserve voting committee have changed their position and now believe deflation is a possibility and have consequently voted in favour of more quantitive easing.The best indicator is the bond market. Through the earlier part of the year the market was indicating a recovery with a return to normalcy and realistic interest rates. The 10-year bond yield crept up to around 3.85%, but something went wrong, and the market reversed course in April. The yield now is around 2.6%. Incidentally, I have spent some time trying to analyse why bond yields changed course. I have overlaid many graphs but cannot find a good correlation. My gut feeling is that investors decided to quit the stock market. Small investors have since fled the market in droves. Investors now feel that US treasuries are the safest investment. This has driven yields to levels previously thought inconceivable. The 2-year has dipped below 0.5%. Thus, the indicator with the most market participants thinks the future is deflation and recession. Small investors have pulled a staggering US$33.12 billion out of mutual funds this year. Since early 2008, Americans have invested US$559 bn in bond funds, and have pulled $235 bn out of equities. They have drastically rebalanced their superannuation 401(k) accounts from growth to conservative options. These small investors might be right: some of my chartist trader friends are sending me frantic email saying that Wall Street is ripe for a catastrophic fall: a Hindenburg Omen. Another chartist friend expects Quantitive Easing to maintain the bull-run. He expects a sharp correction afterwards. A plunging stock market is deflationary. The US already has collapsing housing and commercial real estate assets. It could look like Japan, where property also fell and the Nikkei dived from 39,000 to 9,200 presently. It is the worst performing index this year.
Biflation in the UKThe outlook in the UK is murky. The establishment’s consensus is deflationary. The housing market is sliding and stock prices are not robust (although stiffened by international companies like BHP). The London establishment ( banking Mafioso) has favoured “deflation’ because it justifies creating massive liquidity.Nevertheless, CPI inflation has exceeded the Bank of England’s 2% target for 43 of the past 52 months. It is presently 3.1% and the governor wrote the PM a grovelling letter of explanation. He has written 8 such letters since 2007. His latest is of interest here because he warns of a return to the 1970’s “destructive high inflation”. This is odd, as the BOE keeps its interest rate at 0.5%. Inflation usually trends lower as the economy slows. The British economy is in the doldrums and the expected export boom on the back of weak sterling is a chimera. Credit is still tight. But inflationary pressures are coming from the effects of a falling pound. Imports are much more expensive, and 35% of British spending is on imported goods. Commodities are a large part of that spending as North Sea oil and gas is running out. This import-driven inflation has been over-looked because economists put too much stress on “excess capacity” and labour costs in determining inflationary expectations. As Britain has stable wages and as much excess capacity, the pundits have got it wrong. Radical new research backs up the BOE’s governors fears of a return to the 1970’s high inflation. Andrew Lilico of the Policy Exchange think tank warns that inflation could be 8% in 2 years. He predicts a double dip soon and inflation thereafter with retail prices increasing by 10%. He expects many mortgage defaults and the authorities extending low interest rates out of compassion. This could lead to 20% inflation. Mr Lilico is right wing and close to the PM. But the economics profession lamblast him. His reply is they have no historical perspective: “Policymakers in the early 1990s did not want inflation to exceed 10pc – they simply lost control of the situation and were unable to prevent it. Are we really so confident that there is no chance of policymakers today losing control of events?"
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