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Inflation – not Deflation – is the Threat, Now Here's What to do About it

Keith Fitz-Gerald
Investment Director
Money Morning

We’re “officially” in a recession and the panicky markets are bracing for deflation. But what most investors don’t realize is that inflation – not deflation – is the real threat that they face.

For more than a year now, I’ve been telling readers and attendees at financial conferences around the world that the United States has been in a recession since last November.

I was wrong.

But only by a month: According to the National Bureau of Economic Research (NBER) announcement last Monday, we “officially” entered into a recession last December.

Now, I realize that stocks have taken a drubbing in the past few months. And the odds are good that share prices will get beaten down further in the weeks ahead. But that’s actually good news – and for three reasons:

  • The NBER, which called the recession — apparently from its suite in the “Better Late Than Never” Department — is not known for being timely. In fact, its timing is so consistently bad that this latest recession pronouncement might actually be viewed as the light near the end of the tunnel. Indeed, of the four recessions since 1980, the NBER announced that we were in a recession in a (somewhat) timely fashion only once. That was in 1981, a full six months after the recession actually started.  But in each of the other three recessions – 1981-1982, 1991 and 2000 – the NBER didn’t officially label the deteriorating economic conditions a “recession” until the downturn was nearly over.
  • In three of the past four recessions – 1980, 1991 and 2001 – the Standard & Poor’s 500 Index had already reached its recessionary lows at the time the announcements were made.
  • Since 1900, the average length of a U.S. recession is 14.4 months. Assuming that historical relationships hold true, the NBER data, despite the fact that it’s a year late, falls in line with our suggestions of a few weeks ago that a late springtime rally may be in the works.

(Whether we believe that last point is another point entirely for reasons we’ve written extensively about in recent months. So we won’t rehash those today.)

But we will point out something that’s vitally important right now: There has not been a recession in history that wasn’t followed by inflationary pressure. And that, in turn, suggests that investors would be wise to shore up their defenses now while everybody is looking the other way … at deflation.


The U.S. Federal Reserve is expanding our monetary base by more than $11 billion a day since September to nearly $1.5 trillion, which represents an increase of 79.02% since October 2007.

What they are doing is unprecedented in recorded history.

On an annualized basis, the run rate in just the last few months alone works out to more than 369.92% per year – which means the monetary base is accelerating dramatically (See accompanying chart).

According to the Federal Reserve’s latest H.3 report, dated Nov. 28, bank non-borrowed reserves fell to -$362 billion, more than doubling the -$158 billion reported in September. Meanwhile, the preliminary Nov. 19 two-week figures reflect total borrowings are now $652 billion, up 11.85% over the same time period.

At the same time, total borrowings (TOTBORR) of depository institutions from the Federal Reserve have spiked dramatically, which signals still more money is working its way into the system. Note how smooth the TOTBORR chart has been historically for the last 22 years and how dramatically it’s spiked as a result of the financial crisis. When I say unprecedented, this is the kind of chart I’m referring to.

And we’re not done yet. In addition to all the infusions we’ve already mentioned, Club Fed is poised to inject another trillion dollars to bail out banks, insurance companies, Wall Street, possibly Detroit’s “Big Three” automakers and just about anybody else who “needs” a handout to overcome years of inept management, financial malfeasance – and plain old greed.

That’s why – more than any other single reason – deflationary pressures that might exist in the next six months or so aren’t really the enemy.

Carnegie Mellon University economist Allan H. Meltzer was much more in a recent interview with Forbes, stating that “people who say deflation is a threat are either rumormongers or ignorant.”

Added Meltzer:  “They need to take a refresher course in economics.”

As much as we’d like to dismiss Meltzer’s comments, we can’t. At least not entirely, because interest rate swaps are currently pricing in deflationary expectations.  And that speaks to something I’ve pointed out repeatedly: Any time the Fed squares off against the markets, the Fed loses. And it’s clearly fighting a losing battle now.

That’s why the bond markets are indicating deflationary expectations of 1.5% over the next two years and inflation of just over 0.0% over the next five years. Over the next 10- and 20-year periods, the markets are pricing in inflationary expectations below 2.0% respectively.

With an expanding monetary base already screaming inflation, this connotes opportunity.

The best way to capitalize on this in the long term is through Treasury Inflated Protected Securities, or TIPS. Right now they’re comparatively cheap because investors have fled to straight Treasuries, preferring their immediate liquidity. But TIPs are rising nicely and are likely to rise much
further and faster with the first whiff of inflation. 

Speaking of which, we think there is a 50-50 chance of so-called “core inflation,” which excludes food and energy prices, rising to 4.0%. That doesn’t sound all too bad, but that’s 2.3% more than the recent 1.71% yield on five-year U.S. Treasuries, which means TIPS are a better bet today.

Our favorite, the iShares Lehman TIP (TIP), sports an attractive 8.21% yield and plenty of upside. So it’s not only the good defense we’ve mentioned in the past, but one with plenty of inflation protection built in.

It’s up 14.35% from the low of $84.14 set Oct. 10. That’s something most investors are not focused on right now, but they should be.

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at

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  1. Rick | December 8, 2008

    O my!

    Everybody running carries a “ruptured” money sack!

  2. james | December 8, 2008

    what about the velocity of money?

    Roubini thinks deflation a threat (Financial Times) and he's been on the money so far.


  3. Blake | December 8, 2008

    Good article. The inflationary pressures, history, and the ridiculous government's magical money make inflation much more of a concern than deflation.

    I featured your article on my site.

  4. Marc Abramsky | December 8, 2008

    Well Meltzer has a point. However so does every other pundit who claims deflation is not a long term threat. Yes, inflation will be a short term factor and in truth "some" of the money will find it's way into the market. Notice I quote "some" money. Meltzer needs to refresh himself on what "debt deflation is". The fact he's an economist (which means he's and academic) tells me everything I need to know. He bases his claims on traditional ways that money supply has worked on economies. You print money and prices go up right? Wrong.
    I wager a bet he wasn't around during the great depression to see that money printing had no effect on changing the course of "debt deflation" which is not to be confused with deflation by itself. It is not necessarily a bad thing to have prices for goods more affordable. However when pricing falls as a result of deleverage and bad debt, this on the other hand is not good. Meltzer would know that in deflation alone when a price falls to a specified level you will find a willing buyer who believes that price to be a deal. However when you are bankrupt you don't have cash to buy the item even if it were a deal and low and behold you can't get credit to subsidize your purchase either. What happens next? Prices continue to fall as supply and demand have very little correlation when debt is being realed in. In essence it's a balance sheet problem isn't it? Not a supply and demand problem or a money printing solution. Fear and greed move the markets. These emtions are directly related to why people buy anything. They are also the reasons why markets rarely if ever behave rationally. It is why they are not predictable.
    How often are economists right about any market timing bottom or high? I don't think you need me to state the answer. I rest my case.


    Marc Abramsky

  5. James MacInnis | December 9, 2008

    The metaphore, you can pull a brick across a table with a piece of string but you cannot push it in the opposite direction is quite true. Increasing the money supply and lowering interest rates is not going to entice people to borrow or purchase goods and services they cannot afford.

    In spite of the fact that there is more money then ever before, the global economy is slowing. Much of the money is counterfit because it is not backed up by productivity.
    Deflation is due to a decline in agregate demand. As demand falls producers are forced to lower prices. If this continues prices will fall to where it is not economical to produce and deflation places downward pressure on resource based economies as well. ( The collapse of oil prices is reeking havoc on the Soviet union). As the global economy rachets downward and inventories get used up, the shortage of goods will no doubt lead to inflation.

    This is an international global problem and it will take international cooperation to deal with it.

  6. Stephen Kish | December 8, 2008

    While I agree TIPS are a very good value at this time, I feel that Treasuries are on the cusp of a large decline. If Treasuries take a dive, I'm afraid TIPs will get very wet too!

  7. Joseph D. Allen | December 8, 2008

    With all the loop holes and tax breaks for the wealthy for the last 8 yrs suggest deflation sinec wealth is relative. The increased nation debt suggest inflation since that is the only way the nation can keep from going completely bankrupt. Still confused

  8. James MacInnis | December 10, 2008

    Velocity refers to the velocity of circulation, (the number of times a dollar exchanges hands in an economy). It is influenced by the price level (P). The equation states that Y or (GDP) equals the Quantity of money (M) multipled by the velocity of circulation (MV=PY).

    If the quantity of money(M) is $300 Billion and the velocity of money (V) is 5, GDP or MV equals $1.5 trillion since 5 x $300 billion = $1.5 trillion. Therefore GDP or (Y)= $1.5 trillion.

    Where the money supply is increased or decreased the velocity of circulation is influenced by the the price level (P).
    If increases in the quantity of money (M) are not accompanied by increases in production, prices rise because too much paper is chasing too few goods (Demand pull or classic inflation). However where increases in the money supply are in response to increases in productivity, in the short run, real wealth increases without acompanying inflation.
    However, in the long run, as a result of continuing increases in real wealth and productivity along with increases in the money supply, competition for labor places upward pressure on wages and prices leading to cost push inflation.
    A wage, price and income policy as opposed to monetary policy would work to control cost push inflation but it is politically unpopular, therefore moneytary policy used and this is accompanied by recessions. In conclusion, classic inflation ( too many dollars chasing too few goods) can only be controlled by monetary policy.

  9. Adam | December 22, 2008

    James – "Velocity refers to the velocity of circulation, (the number of times a dollar exchanges hands in an economy). It is influenced by the price level (P)."

    You have is half right. However it is a two way street. If the velocity of money changes and the supply of money does not change then the price level changes according to the change in the velocity of money.

    While the FED is printing money like mad (or so it seems), it does not seem that inflation (for now) is a fear because one would believe that the velocity of money has jumped off a cliff, (note: this is M1 multiplier, which should correlate fairly well with the velocity of money).

  10. Greg | December 24, 2008

    The notion of too little money chasing too many goods, classic deflation, tells us what happens after we are already in the ditch. Whoever wrote this article needs to wake up and look at what's happening. People are afraid to spend money. Less money gets spent, leading corporations to cut back, which leads to less money being spent. When does it tip from a normal recessionary cycle to deflation? That's what Fed is having a problem with. We are having a complete crisis of confidence. Banks lack confidence to lend. People lack confidence to spend. Look at what happened in Japan. It will 10 years for us to put this behind us.


  1. […] Inflation – not Deflation – is the Threat, Now Here’s What to do About it (Money Morning, 12/8/08) […]

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