The flation debate

There are extreme arguments on the both ends of the spectrum in the flation debate.  Since I advocate T-bonds for the next six months, many may perceive me as a permanent deflationist.  But I am not.  All I argued was that in the short term the danger of deflation is clearly a magnitude greater than inflation.  The reasons are listed in my earlier blog on the stimulus debate. 

http://xlpartners.blogspot.com/2010/08/future-intellectuality-of-stimulus.html

For example, in a liquidity trap, which the U.S. have not faced for the past 70 years, no matter how much money you print, it would have no effect on inflation.  Money will not become toilet paper, and they will hold value pretty well.  The only exception is a catastrophic inflation shock like the oil crisis in the 1970s (I also mentioned this in the above-mentioned blog.  In fact, I could have easily expanded each sentence in the above-mentioned blog to a couple of paragraphs, but I thought to save readers some pain). 

The most likely scenario is that we will bounce around zero inflation for quite a few years.  Whether we can get out the liquidity trap is more about politics than economics.  If the two parties can unite, and if we can educate Americans about the very large numbers that I argued in the above-mentioned blog (another two trillion fiscal stimulus and Fed balance sheet totaling 10 trillion through inflation and exchange rate targeting), we will get out of the liquidity trap in no time.  However, the political situation, and the lack of education on this aspect, makes liquidity trap the most likely scenario.  Fed, for example, will only likely step in after deflationary scares (when we have mild deflation) and will likely take away the support prematurely before mild inflation can take root.  A modern democratic society is nearly impossible to use the brutal liquidationist approach that Hoover initially adopted in the face of the market crash.  However, the same society is likely to be balanced by the little Hoovers so that it cannot adopt drastic stimulus. 

So my suggestion of investing in long-term T-bonds or shorting equities in the next six months is based on deflation scare, not permanent deflation. 

http://xlpartners.blogspot.com/2010/08/it-is-still-not-too-late-to-join-party.html

Even if Fed would step in to save the market, they would only act when market is in real danger, and you probably should have taken profits before that time.  I admit that I may have been somewhat early on this trade.  Q4 2010 and Q1 2011 are the earliest periods that we are likely to have significant double dip scares in GDP growth.  Later next year are the periods when we are likely to have significant deflation scares.  I recommended this trade in early August because you would have thought that markets are not as short sighted or overly optimistic as they are now.  In retrospect, it seems to me that the significant T-bond appreciation before September may also be partly due to some prominent hedge funds rewinding their losing bets against T-bonds.  A few were actually closed due to this losing bet. 

So if the U.S. could adopt more stimuli as I suggested, my recommended trade would hurt badly.  I sincerely hope that the U.S. government could follow my policy recommendations, even if this will prove that my trade recommendations are wrong.  Another reason to adopt the inflation approach is because it eliminates substantial amount of debt even at very low levels (e.g., 3%).  Although morality is intuitively attractive, the reality teaches us that we have to forgive the debt anyway, either through defaults (either mass defaults as in the Great Depression or slow burn defaults as in the Great Recession) or inflation. 

http://blogs.wsj.com/economics/2010/09/18/number-of-the-week-defaults-account-for-most-of-pared-down-debt/

However, the political gridlock are only likely to increase more after the mid-term election, and the cautious style of Obama proves that he is more of a politician than an idealist in comparison to FDR.  Maybe we need another disaster before the U.S. can get a more idealistic president in the Oval Office. 

For the longer term, it is crazy to me to only believe in extreme arguments on either end of the flation debate.  I was quite concerned about inflation for a little while too.  But the baseline scenario to me now is near zero inflation for a long while with relatively small inflation risks from potential catastrophic price shocks (e.g., disasters in food supply maybe due to further global warming or conflicts with Iran). 

Some may argue that the U.S. is different from Japan in demographics, which reduces the deflation pressure.  The birth rates and immigration are both higher in the U.S.  The latter may not be of much help because fewer people would come to the U.S. due to the relatively stronger growth outside of the U.S. and because the potential escalating hostility against immigration due to the high unemployment. 

BTW, I understand that PIMCO made some inflation hedges.  The absolute number seems big, but it is tiny in comparison to PIMCO’s overall bond portfolios.  I also understand that import price have jumped, but that is only for a month and the external exposure of the U.S. economy is very small, with imports only being around 16% of GDP.  In fact, the U.S. probably has the lowest external exposure among developed countries and most large developing countries.  I also understand that food and energy prices have increased, but that will take a while to affect the core price index, and they usually do not persist given the generally elastic supplies.