Inflation vs. Deflation...Arguments For/Against and Hedging.
In a different post I out lined an argument and counter argument for each scenario... Deflation, Stagflation, Inflation and Hyperinflation. It was aimed at a BP member wanting to hedge their portfolio. Hopefully it will help others in the BP community by provoking thought and encouraging discussion. Cheers!
Before moving on, I'd like to define two things: Money supply and velocity of money. Money supply is the amount of money that exits, for this post I'll include credit in money supply because credit, to a certain extent, is purchasing power. The velocity of money is how quickly money moves throughout the economy.
DEFLATION, INFLATION, HYPERINFLATION, STAGFLATION AND THE ARGUMENTS
DEFLATION: Deflation, when prices in the overall economy decrease, is most often created by a reduction in spending. This reduction of spending can be a result of less money (credit) in the system or a result of the velocity of money slowing down. When the amount of credit exceeds the levels of income debts can't be paid back and credit contracts. Since credit is purchasing power, when it contracts it creates less spending and lower prices. NOTE: Deflation can also be a result of increased productivity and technology, which is very healthy, but unfortunately that's not the deflation that's applicable to our macro economy today.
Since the early 1980's interest rates have gradually gone down. From almost 20% to today at almost 0% and in some countries negative. Lower interest rates reduce monthly debt payments which allows increased spending without an increase in income. This is why debts, individual and government, have soared in relation to "real" income (adjusted for inflation) and GDP.
One strong argument for deflation is credit, whether public or private, has got to the point were the incomes or GDP can't pay them back. This would create less credit, a slower velocity of money, less spending...deflation.
Another strong argument for deflation is the velocity of money decreasing because of additional regulations and uncertainty. As an example, in 2009 businesses and individuals stopped spending and increased savings due to uncertainty. The individual spending has picked back up but business spending is still slow. Some would say this is a result of increased regulations, others would say it's due to the macro economic environment. It's tough for large business to invest in hiring and R&D when the global economy is so crazy borrowers are being paid to borrow (negative interest rates). The slower velocity, again, creates less spending and deflation.
INFLATION: The proper definition of inflation is an increase in the supply of money. The result of inflation is usually price inflation, which is the more poplar definition. Price inflation occurs when the supply of money increases at a rate faster than the rate of goods and services or when the velocity of money increases. With more money chasing the same amount of goods and services overall prices rise.
A strong argument for inflation is the fact the the supply of money has increased dramatically since 2009. "Quantitative Easing" is a fancy way to say printing additional money. Lower interest rates increase the amount of credit in the system (to a certain point) and the more credit in the system the greater the supply of money.
Based on the level of increase in the supply of money since 2009 we should've seen massive consumer price inflation. Why haven't we? Because the velocity of money has decreased as well. If trillions of additional dollars are created and then placed in a vault somewhere, those dollars won't get into the economy to create inflation. Where has all the money gone that's been created since 2009? Financial assets...stocks, bonds, real estate, art etc. If the fed continues to keep rates low, and theres several reasons they will, increases money printing, at some point that money will flow into the economy. And if the velocity of money increases consumer price inflation would sky rocket. One could argue that the fed could just increase interest rates to slow inflation but that would be incredibly difficult because private and public sector debt would become more expensive creating a recession if not depression.
Another strong argument for inflation is that it helps debtors. As we all know, in terms of total nominal amount, the government is the largest debtor in history. The only way for them to reduce their debt burden is to increase inflation. Knowing that they'll pressure the fed to do everything in their power to create price inflation it's easy to believe they'll achieve the objective. I personally feel the rate of inflation is understated purposely to give the fed an excuse to keep rates low. This increases nominal GDP which increases tax receipts without a need for increased productivity or real income growth. I'm sure you've heard the term "don't fight the fed", if you lean towards the inflation scenario your on the same side as the fed (and the government)...usually that's a good bet.
HYPERINFLATION: Unfortunately theres no precise definition for hyperinflation. When we think of the term we immediately reference Germany, Zimbabwe, and more recently Venezuela. While these examples are definitely applicable I'd propose they're extreme cases and hyperinflation can easily be defined as what the US experienced in the 1970's when consumer prices doubled and tripled in the span of just a few years. Most don't recall but inflation in the US was so bad we had to issue bonds in currencies other than the dollar (called "Carter bonds"). If you suggested this scenario today, I'm sure people would scoff at how impossible it would be for the world to have so little faith in the dollar the US government would have to issue debt in a foreign currency. But this happened within most of our lifetimes.
A strong argument for hyperinflation: As we discussed above americans and our government are incredibly indebted. If interest rates were to increase substantially the private sector and the government would have an incredibly difficult time making the debt payments. Another gentleman that posted showed how an increase in interest rates would create a scenario where the payment on the debt alone would exceed 100% of the tax revenue. Obviously the government/fed can't let that happen. They've backed themselves into a corner where they can't increase interest rates past a certain level without creating a disaster. Therefore if the velocity of money increases, and we see price inflation, the fed might not be able to raise interest rates high enough to combat the inflation. Individuals and governments that own dollars will see this and know the dollars they own are decreasing in value (purchasing power), creating a "hot potato" situation with dollars adding gas to the fire. If the fed didn't raise rates, because they can't increase the debt burden on individuals and government, "hyperinflation" could be the end result.
STAGFLATION: Again, stagflation is price inflation with high unemployment and low demand/spending translating to little or no real economic growth (adjusted for inflation). Prior to the 1970's economists thought this was impossible. It's still a black mark against the Keynesian school of economics, stagflation disproving many of their economic models.
A strong argument for stagflation is just look at the current US economy. Most of the data suggests that it's sluggish at best. The unemployment rate is low but the labor force participation rate is at 40+ year lows. What this means is that there's the same or fewer people working today than there was years ago, yet our population has increased. The unemployment rate really doesn't matter, what matters is the amount of people who are employed and can spend the money they earn relative to the overall population. If the unemployment rate is 4.9% but fewer people are actually earning money because fewer people are in the labor market, from a macro view, it has the same effect as high unemployment.
If you believe that the inflation rate is higher than the CPI put out by the government, then we're in mild stagflation now. To this I'd submit the way the government calculates CPI has changed many times since the 1970's...every time it resulted in the CPI being stated lower than before using the previous method of calculation.
I said I'd mention STAGNATION. This is basically low or no economic growth with low inflation or mild deflation (Japan). If you believe the current CPI numbers then you could argue we've been in economic stagnation for the last few years with the exception of assets which we discussed earlier. It's also plausible we'll continue in this state for many years to come.
*Side Note: Japan's printed staggering amounts of money and has a debt to GDP ratio north of 200% so why haven't they experienced inflation and can't we assume that the US will follow the same path? Maybe, but we need to remember the velocity of money. Due to culture and demographics the velocity of money has slowed faster than the BOJ (bank of japan) can print money. The US doesn't have the same demographic problems and our culture is oriented towards spending not saving. As a result, it's erroneous to assume the US is the next Japan...it may or may not be.
That's deflation, inflation, hyperinflation, stagflation in a nut shell and the arguments for each.
WHAT TO DO NEXT?
Obviously, each argument is a counter argument for the other. Now the question is what to do with the information and how can you use it to take actionable steps towards hedging.
What I do personally, is know that nothing is certain and there only probabilities. To which extent, you need to thoroughly understand, and know the facts, concerning the potential out comes and handicap or give a probability to each, based on your own logic and beliefs.
You already know that inflation favors holding debt and deflation favors holding cash. In a situation of overall price inflation or deflation the equity in your real estate portfolio theoretically doesn't gain or lose purchasing power. Which is why it's been suggested in previous posts equity is the ultimate hedge. I would caution though that this is only true if OVERALL prices are going up or down (including assets). It's possible, potentially even probable, to have asset prices go down with out overall consumer prices going down (i.e. 2009). If housing prices go down or don't rise at the rate of broad consumer prices your equity will lose purchasing power. There are several examples through out the last 115 years where housing prices have decreased in real terms "inflation adjusted." See chart below illustrating this between 1970 and 2014.
My point is twofold. First, when thinking about hedging, understand that there's a difference between overall consumer price deflation/inflation and asset price deflation/inflation, and they can occur independent of one another. Again, the last 7 years are great examples of this. Second, because consumer price inflation/deflation can be independent of asset inflation/deflation, the only way to hedge 100% of your portfolio is to have no equity and a 50/50 split of cash and debt. I'm by no means suggesting this or implying it's even possible, I'm only pointing it out as a theoretical matter of fact.
To summarize, I'd digest all the information, study the data and then access probabilities to each possible scenario, viewing it from the lens of your own beliefs. Once this is done use the probabilities to build a portfolio around your tolerance for risk, need for cash flow, capital appreciation or capital preservation. With all due respect, anyones opinion or how they're hedging should be taken with a grain of salt and that includes mine. No one knows whats going to happen beyond the flip of a coin and everyone's goals and risk tolerance is different. Therefore this should be a very individualized decision.
Below I'll include a youtube link to an animated, very easy to understand, presentation on how our economy works and why we have inflation and deflation in consumer prices and assets. It was done by Ray Dalio who runs the largest hedge fund in the word, Bridgewater. I'd suggest every real estate investor watch it several times. As promised I'll go into behavioral economics to assist you further in a different post because this one is already way too long. And I apologize in advance for typos, poor writing or incoherent thought...I'm at the end of a 3 day water fast so I'm a bit foggy. If you or anyone else would like further clarification please don't hesitate to ask.
I sincerely hope this helps you in your decision making process. Good luck.