Defaltion first, then inflation if we are lucky ;-)
Telemarker - Your concern for inflation is appropriate. Inflation often tends to show up months or years after sharp money supply increases. It shows up quicker (like 9-12 months) when the economy is running near capacity, and tends to have a much longer delay (18 months to as much as 2 1/2 years) when the economy is slowing
Drivers for Deflation -
6) Velocity of money has dropped. Effective money pressure on prices depends on both the money supply (like MZM) and how quickly it moves & turns over in the economy. This movement is know by the delightful term "velocity of money".
Even before the attacks, consumer & business spending was decilining , and consumer savings for August actually increased. This was amplified after the attack, with retail sales and credit card charges dropping sharply.
What might be called the physical velocity of money dropped, as payroll checks delivered by FedEx were stopped and delayed. Also, the bond trading business was severly affected.
This drop in the velocity of money was so sudden that it will absorb all the liquidity pumped in from August to the end of September. It would take consumer behaviour returning to near normal to convert this to real spending which could push prices and wages.
Sharp drops in the velocity of money soak up liquidity - Japan is a good example of this.
5) One BIG source of money during the boom was the reduction of inventories & WIP (work-in-progress, stuff in the manufacturing cycle, like partiallly assembeled cars) . Using electronics, bar codes, tracking software, and good supply chain management, companies were able to reduce inventories for the same sales. Dell is a great example, turning inventory abut 20 times a year, versus the 4-7 typical of average manufacturing. The money squeezed out of inventories was used to pay down debt and buy back stock - especailly when management was heavily compensated with stock otpions ;-)
The slow down in transportation, due to increased security, will require more inventories - this will require money, but that money won't be available to chase goods.
4) Vast oversupply and overcapacity in almost all industry - Want DRAM computer memory ? It's cheap ! Want Natural gas - 1/3 the price of last year. Want a new car, Hey we're DEALING ! How about Class A office space - we'll throw in some cool Aero chairs, some Sun servers, and a foosball table !
You can even get drill rigs !
3) Recent surplus - The Federal government had a surplus of 250 Billion in 2000, and about 150 Billion through July. Much of the money was used to buy back bonds, especially long term bonds. This destroys money.
2) 300++ Billion defaults & downgrades on Telecom bonds and telecom lending - this destroys money also, and will impair bank lending.
1) The 5 Trillion drop in the value of equities. How much of this can be regarded as 'nominal' and how much can be regarded as real I don't know. If we assume that about 20-30% of the nominal value was thought of as a real asset,
then there is a loss of over 1 Trillion dollars. This is not just 'wealth effect' , but real wealth.
This is the 800 pound gorilla of deflation.
The drop in housing prices (just starting) is likely to have some effect also, but slower.
Running against these factors, the Fed and other central banks will pump & pump, just to bail the boat out. I expect defaltion to continue at least until this time next year. Later, inflation will be an almost certainty...but that may take YEARS - Japan has not been able to inflate yet.
Also, I expect inflation to show up selectively at first - maybe silver jumps, and gold follows a year later. Maybe lumber prices soar, and oil prices stay flat for years, or vice versa. Consumer values have shifted as a result of the attacks of 9/11, and the economy will change too, in ways which I can't yet see.
What I am doing - first deal wtih defaltion with solid Treasury bonds, bond funds etc. Second, slowly accumulate a MODERATE amoount some DIVERSE inflation hedges at good prices, such as precious metals & mining stocks, standing timber & forest stocks, stocks with large oil reserves. Except for precious metals, which may have bottomed in June / July, these other stocks are still dropping, so patience and care is in order.
I am not going to bet the farm on inflation occuring on a fixed schedule - remember, in Japan, they are still deflating.
Consider TIPS, TIP funds and I-bonds as way top get both a bond & an inflation hedge.
The more adventurous/foolish may consider shorting/ puts of overpriced stocks, such as technolgy, consumer finance, and some natural gas companies
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I don't beleive the sky is falling - the U.S. economy will just repeat the 1970's to early 1980's , with recession & inflation (Stagflation)
************* A note on the Return of the 70's ********************************
With vigilance by all of us, we can prevent the return of disco music. Rest assured that appropriate agencies of the federal government have John Travolta, the BeeGees and Donna Summer are under constant electronic monitoring.
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