03 January 2013
What Are The Odds? Catastrophic Inflation? Deflation? Stagflation?
With the Federal Reserve “printing” copious quantities of money, many fear a period of intense inflation is highly likely. But the American economy continues to be lethargic. GDP growth projections are not particularly encouraging, and further asset deflation is possible. And of course, there is always the possibility of Stagflation – high rates of inflation accompanied by declining GDP. What are the long term trends that will shape the outcome?
Here are a few thoughts. It’s going to be an interesting four years: 2013 – 2016.
Future rates of inflation are likely to be driven by current Federal monetary policy. The Federal Reserve will continue to buy government debt and agency mortgage bonds to enable monetary liquidity. These moves will further erode the value of the dollar. As the value of the dollar declines, the rate of inflation will increase.
As business and consumer loan activity picks up, the money supply will shift from bank reserves and business cash balances, to money flowing through the economy. As the speed of the flow increases, inflation will increase.
Public debt financing, along with entitlement and contract obligations, will force Federal and State government administrations to increase taxes. The “Fiscal Cliff” agreements will be trashed. Look for increases in investment, estate, property, income, sales, and corporate taxes. The idea that only incomes over $200,000 ($250,000 for married couples) will be taxed is a politically expedient myth. Every worker will pay more personal income taxes. The cost of living goes up.
Obama Care, Medicare, and Medicaid costs are out of control. Few states can afford the cost of proposed and imposed mandates. Medical care continues to be a critical driver of inflation.
College, university, high school and grammar school costs will continue to escalate at rates that exceed the base rate of inflation.
An increasing percentage of America’s wealth will be allocated to public debt service rather than growth investment.
Federal Environmental Protection Agency (EPA) rules will continue to increase consumption and investment costs, while decreasing economic growth. Proposed Cap and Trade rules will raise the price of goods and services for all consumers and businesses. It’s all inflationary.
State environmental, medical, worker’s compensation, welfare and other laws increase the cost of doing business. Lawmakers typically ignore the economic damage. The decline of economic activity ensures higher rates of unemployment. Businesses that manage to survive will have to raise the prices they charge for the goods and services they sell. (California is the economic model).
Fracking technology has sharply increased the supply of natural gas. Prices have declined, and natural gas is being substituted for other fuels in the generation of electricity. It’s all deflationary.
Although fracking technology will increase the recovery percentages for some existing oil fields, and promises to increase the flow of oil from new wells, environmental opposition is likely to impede American production. If there is relative peace in the Middle East and Africa, oil prices are likely to be stable. If either geographical region experiences a surge of conflict, then oil prices will go up – perhaps sharply. Prices will increase, and drive a period of inflation, until the underlying conflict is resolved. World oil prices primarily impact the consumer through price changes for gasoline, diesel, propane, kerosene, and heating oil fuels. The price of oil also impacts the price of food, bulk products made from oil, and transportation intensive services. (Note 1)
The economy will stall, investment activity will decline, and the rate of inflation will continue to increase. Current expense items –including food, fuel, and rents – are particularly vulnerable.
At some point, the stock market will collapse. Aggregate stock valuations decrease by more than 20 percent.
The value of the dollar continues to decline through 2016. Confidence in the financial viability of the public sector erodes. Several states will need federal bailouts in order to stay afloat. Public debt ratings decline. Foreign lenders become reluctant to purchase public debt without significant monetary and financial reforms. Federal and state agencies will have to pay higher rates of interest in order to offset the perceived risk of buying public debt. It will become increasingly difficult and more expensive to sell new bonds, or to roll over maturing issues of existing public debt. As public sector bond interest rates go up, bonds not held to maturity will decline in value.
Recession makes it increasingly more expensive to sell new bonds, or to roll over maturing issues of existing private sector debt. As interest rates go up, bonds not held to maturity will decline in value.
Under normal market circumstances property values tend to follow the rate of inflation in other economic sectors. As inflation sets in, property values will be flat or slightly lower. Bricks and mortar are seen as a hedge against inflation. Sellers will want to keep their existing properties because they will expect property values to increase as the value of the dollar deflates. But for people who are forced to sell, buyers will be more difficult to find. There will be fewer qualified home buyers. Inflation has eroded their net worth. They no longer have enough cash to make a down payment. High interest rates and property taxes decrease the price they can afford to pay for a home. For a cash buyer, there will be deals (think Argentina).
In periods of high inflation, accompanied by declining economic activity, rental property owners (homes, apartment buildings, shopping malls and so on) face potential bankruptcy because of higher vacancy rates. It will also become increasingly difficult for rents to keep up with ever higher property, debt, tax, and maintenance costs. Rental property values decline.
With higher taxes and debt costs in place, expect a reduction of business activity, and a decrease of productive employment. Corporations will be more reluctant to invest in fixed assets or hire new employees.
Bond devaluations and declining property rents would jeopardize the asset base that supports existing pension plan and insurance annuity contract payments.
Annual inflation exceeds 10%.
Since liberal economic and social philosophy dominates America’s political agenda, we can expect liberal financial solutions will be imposed to solve America’s financial problems. Liberal ideology is unlikely to support the creation of national wealth, and very likely to increase government spending. Growth in public employment is seen as beneficial. Fiscal discipline is (deliberately) ignored. The net effect will be to drive America into a long period of high inflation accompanied by declining business activity, high unemployment, high underemployment, and an increase in poverty. Expect widespread social unrest.
Chronic recession accompanied by inflation – that sounds like Stagflation.
But, I could be wrong. Although the above points do not suggest a growing and prosperous economy, we can not ignore the amount of wealth that still exists in America, nor can we forget the American entrepreneurial spirit. So the economic progress of the next four years could be substantially better than these points would indicate.
Judge for yourself.
Note 1: for more information about food and fuel inflation see: http://www.tceconomist.blogspot.com/2011/05/inflation-parade-of-zombies.html
For an analysis of the relationship between the price of oil and the rate of inflation, see: http://www.tceconomist.blogspot.com/2011/06/how-does-price-of-oil-change-rate-of.html