As you probably know, in recent months there has been a heated debate among economists and politicians regarding inflation and deflation. The camps are divided over the direction of our economy with regard to both scenarios. As you may remember, I covered the arguments for and against both inflation and deflation before the New Year. While most investors are concerned with the prospects of either scenario ravaging their portfolios, many have failed to examine a little known theory on the subject that combines both inflation and deflation. What may be the situation at hand is a scenario where both parties are correct to a certain degree. With the current economic situation in the United States as well as the changing geography of the global economy, it could be that both camps are right, but neither argument can describe the situation entirely. Meet biflation, the stagflation of the 21st century.
Biflation is a relatively new economic concept¬¬¬ that was initially outlined by the economist F. Osborne Brown in 2003. Some commentators have been quick to view biflation as stagflation all over again. However, there are clearly defined differences. The ingredients of stagflation are simply a stagnating or recessionary economy against a backdrop of inflation across the board, with price increases in nearly all categories. Since biflation is an emerging concept, many economists are in disagreement with regard to its definition. In spite of that, several private economic research organizations have loosely defined biflation as an economy where inflation of commodity-based assets occurs alongside the deflation of debt-based assets.
First, let’s take a look at the inflationary aspect of biflation. Many economists and commentators, myself included, have argued that the money supply injected into the economy by central banks worldwide will lead to higher inflation in the future. If the economy goes through a biflationary stage, this is destined to be at least partially correct. The prices of commodity-based assets such as food, oil, and metals will increase. With the developing economies in Asia, demand for such assets, particularly food, will continue to grow. The price increases will be exacerbated further by the excess money supply pursuing the limited supply of goods. Such is the inflationary aspect of biflation.
One of the most prominent voices in predicting inflation has been financial guru Jim Rogers. After establishing the Quantum Fund with George Soros in 1970, Rogers went into semi-retirement in 1980. After stints as a professor, traveling extensively, and writing about his motorcycle trips around the world (Investment Biker and Adventure Capitalist, both great reads if you are interested), he moved to Singapore in 2007 to be in closer proximity to the growing Asian economies. He has emerged in the past few years as one of the strongest proponents of future inflation. When asked in a recent interview if he feels that the US will be hit by inflation due to Bernanke’s actions, he quickly cut the interviewer off, saying, “Not just the Federal Reserve. All central banks are part of the problem. We’re going to be paying more for just about everything down the road.” When asked if he foresees a 1970s-style period of stagflation ahead, Rogers replied with a smirk, “I hope it’s that good. It might be much, much worse.”
Every new set of data that points to inflation seems to be offset by an accompanying set of data that suggests otherwise, leading to mixed conclusions. We have seen oil continue its robust recovery from the violent, margin-induced selloff of late 2008 (refer to Chart 1). For the first time in nearly two years, the prospect of $100/barrel oil is once again a possibility with the spring and summer driving season approaching. The price of oil is now identical to that of October 2007, when the S&P 500 reached its all-time high. Gold, while still $75/oz. off its early December high, has also recovered 50% from the late 2008 interim lows. Across the world, government statistical agencies are reporting increasing levels of inflation. Last week, India’s annual inflation rate for March was reported at 9.9%, up from less than 2% last September. Consequently, on Tuesday the Reserve Bank of India (RBI) announced its intention to continue the trend of raising rates in the foreseeable future. The RBI’s governor described the situation as “worrisome.” This sudden increase is not limited to Asia. Inflation has now hit the UK, rising to 4% according to the most recent data. This exceeds the Bank of England’s internal 3% inflation target.
Chart 1 – Light Crude – Continuous Contract: April 2007-Present
Note that the 50-week moving average (Blue Line) is about to cross upward through the 200-week moving average, which despite the 2008 selloff, has remained steady due to oil’s recovery.
Now for the deflationary aspect. When the talking heads engage in this debate on CNBC's Squawk Box, Charlie Rose, or other programs, the general argument for deflation is that there is a large housing glut that will take years to wear off, in addition to excess capacity in manufacturing and many other areas of the global economy. The economy has been held down by increasing unemployment and decreasing purchasing power even as the recession has begun to abate. With individuals and families cutting back on spending, a greater amount of household income is directed toward buying essential items. Therefore, large purchases (read: debt-based assets such as McMansions, appliances, automobiles, etc.) increasingly fall into lower demand. Prices for these items remain stagnant, if not decreasing, and these sectors of the economy experience the deflationary aspect of biflation.
At the same time we have been receiving inflationary reports and data, other economists continue to ring the deflationary alerts. As I have mentioned in previous commentaries, the prospect of our economy falling into a destructive cycle of deflation is a scenario that our country’s fiscal leaders are willing to do nearly anything to prevent, up to and including debasing our currency. Despite that, some deflationary risks remain. The real estate market, after stabilizing in 2009, potentially could take another downturn via commercial real estate and a great overhang of housing supply that is not even on the market, often referred to as the “shadow housing inventory.” Many stories appearing in the financial media in the past several months have pointed out that despite foreclosures falling in number, the number of properties eligible for foreclosure has continued to climb through 2009. Fifty percent more US home mortgages are now seriously delinquent than during the heart of the financial crisis in late 2008. The rate is 9.67% now compared to about 6% then (refer to Chart 2). In fact, it is estimated that five to six million properties are eligible for foreclosure but have not been repossessed. I have seen a range of predictions, but the median estimate of economists is that it will take about three years for the housing market to digest the excess housing inventory.
Chart 2 – Seriously Delinquent US Home Mortgages 2005- Present
Deflationists are also supported by the lack of credit available to most small consumers and businesses, which continues to keep a lid on economic growth. In early February, the Core CPI figure fell by 0.1%, the first such occurrence since the early 1980s. This sparked fresh fears over a return to a deflationary environment, but moreover it reminded many that the recovery is modest at best, and therefore prices have good reason to remain contained. As with the inflation camp, there are some who feel it is a sign of things to come. Mizuho Securities Chief Economist Steven Ricchiuto said in February that even though core wholesale prices rose 0.3% in January 2010, they have only risen 1% in total since January 2009. Further, Gluskin-Sheff economist David Rosenberg, formerly of Bank of America, sees deflation as the “primary risk” to investments in the near future, noting that “it is truly difficult to believe inflation is going to be revived in the intermediate term.”
So what’s the verdict? I think it is reasonable to say that our economy is showing both ingredients of biflation, regardless of a universally-accepted definition. The prices of oil and food staples appear to be headed higher while home prices have begun to slide once again. According to home price tracker Zillow.com, house prices slid more than 6% in February and March. Obviously, the relative lack of credit is still a thorn in the economy’s side, and with the first-time homebuyer tax credit coming to an end, there is potentially another down leg coming up in real estate. If figures begin to tilt on the deflationary side, central banks may increase their intervention once again, propping up sectors of the economy that are experiencing deflation but having the inverse effect on the inflationary sectors. Along with rising worldwide demand for food and commodities, it could become a vicious cycle of biflation until home prices begin rising once again on a sustained basis, and rates are raised to the point that prices can be contained. Needless to say, raising rates with the situation the US is up against will be a heated topic of debate if inflation does take over. Unlike in 1980 when the US enjoyed the status of being the world’s largest creditor, such is not the situation today. Raising rates in earnest to crush inflation could be difficult with the debt our government will need to continue issuing. But this is a discussion for the future. Until then, biflation could be the situation for some time.
Respectfully Yours,
Matthew R. Green
April 22, 2010
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