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June 9, 2010

Inflation versus Deflation, Which Way Are We Headed?

For the past year, the government’s intervention of our economy has created a debate as to where we are headed from here.  Some economists believe that the crash in the housing market and the financial crisis may only be starting and could lead to more deflation.  Others argue that the massive creation of money will eventually be put into circulation in our economy and with not enough goods to make up for that increase, inflation will occur. 
Let’s use some Mint charts to examine the causes of both deflation and inflation and see where they apply to our current economic situation

The deflationary cycle in the picture is what economists on this side are citing when engaging in the deflationary debate.  Specific to our current economic conditions, the following statistics show that deflation is still present in our economy:
1)      Unemployment remains high.  The U-6 has not declined since the so-called recovery began.
2)      Prices are still under pressure as shown by the recent negative number release in the producer price index.  Lower prices pressure producers to supply less (per the laws of supply and demand).  This will also persuade them to hire less.
3)      The foreclosure crisis is ongoing.  Despite the “freeze” imposed by the administration, foreclosures are expected to be higher in 2010 than they were in 2009.
4)      Banks and other financial institutions still need to write down and dispose hundreds of billions in toxic assets.  This works to destroy the supply of money.
5)      Fear, which is a factor in causing deflation, is still present.  This can be seen in uncertainty amongst investors to invest, small businesses to hire, and consumers to consume.
6)      Deflation is still a threat for one to two years out.  We can wait to handle the possible inflationary consequences.

People who believe that inflation is the current/on-coming threat believe the following:
1)      The economy has begun to grow, as shown by the recent GDP figures.
2)      Consumer prices are rising, as shown by the last few CPI reports.
3)      The government has created at least one trillion dollars since the onslaught of the financial crisis.
4)      Banks are holding hundreds of billions in TARP funds in reserve accounts or in U.S. treasuries, when this cash is released into the system, it will cause inflation.
5)      The Federal Reserve is following the same easy money policies as it followed from 2001-2004.  Inflation was at 6% before the housing crisis.
6)      Inflation does not appear “as scheduled,” therefore waiting for it is foolish.  With the amount of money in the system chasing too few of goods, by the time inflation becomes apparent, nothing less than a recession (like in 1981) will be able to stop it.
So which side of the deflation/inflation debate do you fall on?  Are there any other deflation/inflation points that you would like to share?

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