The Big Question for Investors-Inflation or Deflation

Investors are scratching their heads asking: “What in the world is going on? What is real? What should I believe?” There seems to be no consistency. On the one hand we have the Dow Jones Industrial averages making new highs, yet unemployment is not coming down enough and the housing sector while ticking up a bit it still has not regained its pre- recession values. Fully one third of homeowners still have negative equity. This is the big question for investors – inflation or deflation?

When the crash or 2008-09 occurred the US Federal Reserve took the reins and started the most aggressive stimulus program in US history. The theory was that if enough money were pumped into the economy, it would recover quickly, that unemployment would drop and the housing market would take off. Neither of these two initiatives has come to pass. Yes, unemployment has ticked down a bit, and housing prices have risen in some areas but many parts of the country, especially the heartland have not been part of the upswing.

The aggressive stimulus was also designed to prevent “deflation.” The Fed Fed outright stated that they want at least 2% “inflation.” After nearly five years they are finally getting that number. Simultaneously, they drove interest rates to near zero.

Now we come to the big fork in the road. So far, the stimulus programs have created $2.25 trillion extra dollars. These dollars flow from the Federal Reserve into the bank coffers. When the Fed buys treasuries or mortgage backed securities, it credits either the bank or most likely Fannie Mae and Freddie Mac both of which had to be bailed by the Fed. This was intended to keep them in business so they could keep issuing new mortgages. Both Freddie and Fannie had 80% of all US mortgages at the start of the crash.

Some economists believe that all of the excess stimulus will lead to hyperinflation, with people chasing goods at higher and higher prices.
Interest rates will rise making it more costly to borrow and conduct business.

So where did all money go from the Fed’s stimulus? Much of it went into the stock market, driving prices to new heights. Let’s face it the dramatic rise in the stock market since 2009 was not brought about by mom and pop orders. It was done with large chunks of buying from banks and hedge funds.

Still there should be more inflation. What happened? The Fed cleverly started paying interest to banks when they parked their money at the Fed. Banks are now sitting on a whopping 81.5% of excess reserves. They simply did not lend it out.
The Fed wanted this to keep inflation low. If banks were not lending, the multiplier effect of issuing loans was kept in check.

Now we come to the demand side and the consumer. Real wages have barely risen if at all during the past five years. Consumers who account for 70% of our economy are strapped and are spending only for necessities.
True inflation is in food and energy that are not included in the Fed’s core index..
Technology has advanced rapidly displacing many long- term workers. These persons have not been able to find new employment. The latest job numbers fell short of expectations at 169,000 when the Street was expecting 180,000. Downward revisions were made for June from 188,000 to 172,000 and for July from 162,000 to 104,000. The U-6 unemployment report that tracks discouraged workers, underemployed and part time workers is showing unemployment at 14%. Some states like California are showing numbers like 18.3%, Oregon 16.9%, Michigan 16.1%, Los Angeles county 20.5%, Nevada 19% and New York City 15.1%.

We have several citywide bankruptcies, most notably Detroit. With proceedings going forward one big question is to what extent pensions will be reduced or eliminated.

For investors it is important to follow all the moving pieces. Keep in mind that all of the above factors are intertwined with ripples flowing through the entire economy.

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