Here’s How Inflation Can Lead To Deflation

This is a difficult blog to write without oversimplifying things. Predicting the economy is like predicting the weather. We know the seasons will have certain characteristics, but we don’t know if the hurricane comes on September 22 or September 23 when we are 6 months out. With the economy, we know there are seasons predicated not on the earth’s position in relation to the sun but political policymakers and human nature.

Some time ago I rang the alarm about inflation, Stagflation: And So It Begins. I was a bit early, but your last visit to the gas pump and grocery store has confirmed I was correct. Now that I have you wringing your hands about excessive inflation let me explain a possible intermezzo between acts: Deflation. Here's how it could work out.

Act 1: People realize that big ticket items are overpriced. They put off buying the refrigerator, the used car or the new home.

Act 2: These items start spending longer times on the shelf and sellers slash prices. The time between Act 1 and Act 2 can be very long. Or more accurately the excitement if rising asset prices between Act 1 and 2 can lull us into thinking that Act 2 will never come.

Act 3: Concurrent and independent of Act 1 and 2, interest rates rise and lending standards get restrictive. Mortgage rates and credit card rates go up, but it's also harder to get easy credit for individuals and businesses.

Act 4: The smart people in the room see deflation coming and seek to pay off their debts. To get the money, they sell their assets like stocks and real estate. This adds fuel the price slashing of Act 2. Soon and quickly nobody wants to be left holding the bag. Just like everybody was buying irrationally before Act 1, everybody is irrationally selling in Act 4.

Ok then, the next question is, "So what?" Deflation appears out of nowhere and causes rapid and disorienting declines in asset values. Think 2008 to 2009. This is why we don't believe in buying high quality stocks and bonds and holding for the long term. The 1970's and 2000's showed us that inflation, deflation, government regulations and just plain old human nature will create volatility that we can't possibly predict. However, technical indicators give us a way to catch the bulk of inflationary and deflationary trends.

Related: The Brighter Side of Inflation