July 18, 2017

Many investors pigeon-hole themselves as “inflationists” or “deflationists”, where an inflationist is someone who expects more inflation over the years ahead and a deflationist is someone who expects deflation. I am grudgingly in the inflation camp, because the overall case for more inflation is strong.

I use the word “grudgingly” in the above sentence for two reasons. First, more inflation adds to the existing economic problems and will eventually result in major social upheaval, so when I predict that there will be inflation as far as the eye can see I don’t want to be right. Second, it means that I get lumped together with the perennial forecasters of imminent hyperinflation, even though my only mentions of hyperinflation over the past 17 years were to explain why it had zero probability of happening anytime soon.

With regard to the US situation, the main reason the case for more inflation is strong is that it doesn’t depend on private-sector credit expansion; it depends on the ability and willingness of the Fed to monetise sufficient assets to keep the total supply of money growing. A consistent theme in my commentaries over the 17 years since the birth of the TSI subscription service has been that the Fed could and would keep the inflation going after the private sector became saturated with debt.

Prior to 2008 there was very little in the way of empirical evidence to support the belief that the Fed could keep the inflation going in the face of a private-sector credit contraction, but that’s no longer the case. Thanks to what happened during 2008-2014 we can now be certain that the Fed has the ability to counteract the effects on money supply, asset prices and the so-called “general price level” of widespread private-sector de-leveraging. The only question left open to debate is: will the Fed CHOOSE to do whatever it takes to keep the inflation going in the future?

Based on the publicly-stated views of those who operate the monetary levers as well as on the economic remedies prescribed by today’s most influential economists and financial journalists, there’s a high probability that the answer is yes. At least, there is a high probability that the answer will be yes until the fear of inflation becomes much greater than the fear of deflation. However, the Fed is faced with a difficult challenge. It does not (I assume) want to engineer a steep decline in the dollar’s purchasing power, so every step of the way it tries to do no more than the minimum necessary to ensure a steady and modest rate of purchasing-power loss, with 2%-per-year having become the semi-official target.

The challenge is actually more than difficult; it’s impossible. The impossible-to-solve problem faced by the Fed and all the other central banks is that it can never be determined, in real time, what the aforementioned “minimum” is, because money-supply changes affect the economy in unpredictable ways and with large/variable delays. The economy therefore ends up careening all over the place and we occasionally get deflation scares, which are periods when it seems as if genuine deflation is about to happen. Paradoxically, the deflation scares are highly inflationary because they always prompt the Fed to ramp up the rate of money pumping, but while a deflation scare is in progress it can feel like the deflationists are finally going to be right.

I’m not ruling out the possibility that the deflationists will eventually be right. I hope that they will be right in the not-too-distant future, because more inflation will only add to the economic distortions and lead to an even bigger problem down the track. It’s just that they are, in effect, betting that devotees to the central planning ideology will suddenly realise the error of their ways and let nature take its course. The odds are very much against this bet paying off.

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