Deflation and Inflation

So the number one burning question that I am focused on today is that of inflation vs. deflation. It is interesting in that through the first 8 months of this year, everyone seemed to be absolutely convinced of very crippling inflation. Now everyone seems to be 100% convinced of deflation. Despite this being what I consider the most critical question we face as investors and Americans, I haven't found much good subject matter on it. Here are my thoughts in the form of answers to some basic questions. If I am wrong, please step into correct me.

HOW MUCH DOES THE US NEED TO FUND?
While it does seem like deflationary trends are indeed in full bloom, the lurking nature of inflation seems to be not to far in the background, or our futures. The government seems to be only days away from monetizing the huge volume of debts that the federal government has been forced to put on its shoulders in recent weeks. Lets count them up:

Fannie Freddie Losses: $1 Trillion (presuming roughly 20% loss on prime mortgage assets)
AIG: $122 Billion
Government Bailout Package: $850 Billion
Money Market Fund Guarantees: $540 Billion
TOTAL: ~$2.5 Trillion

Now those are rough numbers but these are still early days. It is also important to note that of the government bailout package, $250 Billion of that is bank equity infusions. Compared to the Euro Zone's $2.5 Trillion bailout, the US government seems to be at least another $1 Trillion short of the dollars necesssary to fund the banking losses. If you layer on additional dollars to shore up money market funds and other commercial paper losses, and the dollars pile up. But for now, let's stick to the $2.5 Trillion number.

WHY DO WE WANT TO EVEN FUND THESE LOSSES?
The big lesson of the Great Depression apparently was that we would not want to allow another massive deflation event to hit the US economy. This Great Depression was really a big deflation of asset values and prices, exacerbated by a strong dollar pegged to gold, isolationist tariffs, and unaddressed liquidity issues in the banking system. Given this, Ben Bernanke and Hank Paulson have initiated a set of policies designed to reinflate the system and combat the debt deflation spiral that would lead to falls in prices, significant job losses, credit losses, and more. While it is still not clear that inflation is better than deflation, the vested interests in the government seem very much aligned towards this type of policy response.

While one would envision this opinion to be expressed to lawmakers only through Wall Street types and Fortune 500 CEOs, it will also be seen fully as a liberal cause once the major pension plans (e.g., CalPERS) announce year-end losses of up to 40% on what was once their $200 Billion portfolios. http://online.wsj.com/article/SB122469119659558689.html. Keep in mind that CalPERS and the big pension fund groups of the US will have massive, unrealized losses on their private equity and real estate portfolios that will not be "marked-to-market" due to loose reporting standards for doing so. In other words, Thank goodness for Level 3 assets! The only way out of these losses is to reinflate asset values.

Interestingly enough, the amount by which they will need to reinflate these values will require even more effort on the Fed's part as we are seeing risk premiums expansion in the form of lower P/Es for companies and higher cap rates for real estate, which will need to be offset by increasing net operating income. Doing that in the middle of a long recession will be tough. The only way to do it is through nominal revenue increases. Sounds like inflation to me as real gains will not be available anytime soon. No one said it would be easy! OK, it will only be a nominal improvement, but it will make people feel better.

On top of the political impetus for reinflation, that has been the whole source of Ben Bernanke's academic research and writings. Attached is a great read for those who want to understand more about BB's thoughts on tools to reinflate. http://www.gloomboomdoom.com/gbdreport/download/GBD0602.pdf (Start reading on Page 5).

HOW DO WE FUND THESE LOSSES?
It seeems that there are three ways to fund these losses. 1) We can issue new Treasury securities, 2) We can print more cash, and/or 3) We can charge more taxes. My guess is that we do some combination of the first two. The third does not seem like an option at all given the myriad needs for what should be a shrinking tax base.

Treasury Market
At last count, the total Treasuries in the market total roughly $4.8 Trillion (we do not include Fannie and Freddie debt which is held "off balance sheet"). This includes everything owned by China, Japan, private institutions, and individuals. If we were to fully tap these markets for the full $2.5 Trillion, we would increase the total Treasury supply by over 50%. That is a massive increase given that it took us some 225 years to get to this point. The question is would there actually be buyers to show up to purchase the bonds if they went for sale. We will find out as time goes by.

The natural target for these bonds are the Chinese, Japanese, and Middle East. They bought them largely with US dollars they acquired as a function of the US's consumer-driven current account deficit. But the US current account deficit peaked at $800 Billion in 2006 and has been shrinking since. Yet as the current account deficit shrinks, they will have fewer and fewer US dollars to buy this debt. 2008 will probably come in at $600 Billion or less. In 2009 and beyond it will likely be even less as US consumer spending further weakens. If the dollar amount of Treasuries is at or less than $2 Trillion, we may come out all right. If it is more, we won't be able to keep issuing Treasuries to fund these costs.

And don't forget that Treasuries are yielding what are the lowest yields soince 1977, when the 30-year bond was first issued. It is conceivable that the issuance of more Treasuries will cause yields to increase dramatically.

Print More Cash
This is obviously the cheap short-term answer. In many ways, it would be a flat tax across all holders of US dollars, domestic and foreign, as an infusion of capital should reduce the value of all USDs in circulation. The infusion of capital into the banks may very well take this form. I suppose this is what is meant by the US government's "exclusive privilege" of being able to print unlimited US dollars to pay US denominated debts. Ironically, and much to the US government's benefit, they will actually reduce the value of their liabilities and increase the value of their foreign holdings if they force a devaluation of the currency. From that perspective, printing more dollars, forcing a currency devaluation, seems to be a great idea. It is certainly politically expedient.

Raise More Taxes
There is already talk of another tax stimulus package. And given Ben Bernanke's stated preference for another tax stimulus, that would provide cover for many politicians to provide just such a stimulus package shortly. This further deficit will need to be funded, of course. Likely through one of the above two methods. Given that there is already a big federal budget deficit, cutting into entitlements AND raising taxes to funnel tax dollars to pay off the bailout package probably won't have a lot of political support.

CAN'T THE FED STOP INFLATION?
They normally could with the standard Fed toolkit which consists primarily of 1) selling Treasuries to sop up cash, 2) pushing the Fed Funds rate upwards (a la Paul Volcker when he pushed rates to nearly 20%), or 3) raising reserve requirements. However, as a creditor nation with huge outstanding debts and a fragile banking system, these three tools are severely impaired. The Fed balance sheet may not be able to issue many more Treasuries above and beyond the required amounts and even if they did, who would buy them? And pushing short-term yields (which is what the Fed controls) to 10%+ may not be feasible given the need to service the outstanding debt. Raising reserve requirements will be a tool that they could use but they would likely have to do so with a very fragile banking system in the midst of rebuilding itself. But it could work to tighten money when the time comes. So the Fed will likely be stuck keeping rates low, feeding the system with the same kind of loose money that caused the credit problems in the first place.

BUT CAN THE FED STOP DEFLATION?
This is really the big question. If they can't stop it, then our course towards a Japan-style deflation is set. However, Bernanke himself declared in a 2002 speech that it was really the lack of political support in Japan that prevented the Central Bank from reinflating. It doesn't seem as if there is any internal political divisions around the need to reinflate here in the US. The failed first bailout vote aside, it appears that the political direction will be around reinflation particularly given the aforementioned pension fund losses which will affect big Democratic power bases, such as teacher and laborers. As he further notes, "deflation is always reversible under a fiat money system follows from basic economic reasoning". However, despite Bernanke's stated optimism in having a broad enough range of tools to beat deflation, it is not a certainty. But he will throw the kitchen sink at beating it back.

OK, SO NOW WHAT?
Deflation is clearly happening today but it is somewhat likely that the Fed will succeed at some point in the using the US government balance sheet to reinflate the credit, and as a consequence, the asset markets. While it is perceived as a binary outcome, we could see inflation in things we use and deflation in things we own. That is the worst possible outcome of all. How would that happen? The inflation could cause a devaluation of the currency, raising import prices which would ultimately spur rises in domestic prices as well, although with a lag to it. A weak dollar would also cause a rise in commodity prices, in particular food prices and precious metals which would presumably still be priced in US dollars.

But this type of inflation would be bad for many stocks as the costs of inputs would rise and PE ratios would fall as the risk free rate would significantly increase. However, stock prices could stabilize or rally if the dollar falls which would result in a nominal gain, but a real loss. Bonds would definitively be damaged in such a scenario. Anyone have thoughts on what this means for distressed fixed income investors? I would curious to get a perspective.

However, at the end of the day, it all comes down to timing. At some point, the inflation bets, should inflation occur, will pay off but that may not be for awhile. For example, the performance of gold has been less than exemplary over the past two weeks and could continue to head lower. And needless to say, real estate hasn't exactly been caught in an inflationary spiral.

A good trade to get things started could be short long Treasuries. I think they would weaken from current levels in both deflation (real credit risks and/or fear of future currency debasement) and inflation (higher required yield) scenarios. Not to mention that at some point people will want to risky assets again and may all try to move out of Treasuries at the same time.

In all things, it is important to remember the saying, "Being early is indistinguishable from being wrong."