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Tuesday, October 21, 2008

Inflation vs Deflation

Every day brings an onslaught of news, today is no different. However, most of the news isn't earth moving, so I decided to talk about inflation vs deflation. Why? Because what the USA is and will experience between the two choices affects where is best to invest. I'll give my high level spin, feel free to click on the two links above to get the full version from Wikipedia.

Inflation is where there is "too much money" chasing "too few goods". Think of an "over-heated economy" or a banana republic printing cash like a free photo copy machine. The value of the currency is "less" and therefore it takes "more currency" to purchase an item.
Currently the USA is experiencing for 2008 inflation rate of about 10-12%. That means if you did NOT get a 12% raise this year, in effect you have taken a pay-cut relative to your expenses. Further if your investments and assets did not grow by 12%, you are less rich.

Typically in an inflation environment, interest rates rise for debt, to compete with the inflation effect on currency. For those 40+ year olds, this would be best described as what was experienced in the USA during the 70's. Inflation generally speaking punishes those with cash or low interest rate bonds.

Deflation is where there is "not enough money" to go around, and goods/services prices drop "chasing" money. As an example, housing, retail goods, stocks, interest rates, and other prices drop trying to attract cash to the business. In the modern world, this is also typified by "credit collapse" where money is not created through lending. Money is horded, not spent. The Great Depression was a good example of a deflationary environment in the USA.

What the Federal government is trying to do is print/create money as quickly as possible over-power the forces of deflation. The problem is how can the government "inject" cash into private hands, and how can the government insist people lend to each other?

Deflation generally rewards those with cash, or low interest rate bonds. "Cash is King" at the depths of an deflation collapse, allowing the cash to buy goods on the cheap.

That is what we are facing today, we are in no doubt, a deflationary collapse. The bigger question is, how long will it stay deflationary, and will the unprecedented lending and printing of money by the government eventually result in inflation or hyper-inflation?

In my blogs, this is why I have stated the best place to be is in federal bonds, but be prepared to flip out into other investments. In an hyper-inflationary environment, buying gold, oil, and possibly stock is a way to preserve wealth as the USA dollar collapses in value.
My Spin: The USA stays deflationary into 2009, and if inflation does gain steam, it will be due to the over-reaction by the federal government flooding with free cash now. Or possibly mix of the two, higher interest rates for debt AND deflation. In any event if interest rates rise it will further cripple the real estate, states, federal government, companies, and the consumer as the USA debtor nation has to pay more for it's debt. The next president (Obama?) may take the blame for inflation due to that president's policies. But the reality will be the actions taken today seal the US fate next year.
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