Expert Commentary

Inflation vs. Deflation

This article was originally published in Robert Prechter's June 2009 issue of The Elliott Wave Theorist.

Inflation vs. Deflation

In recent days, at least six very famous and globally respected financial gurus announced that the dollar has begun a phase of hyperinflation, and many lesser lights have echoed their feelings. Here are some of the comments issued publicly over the past week:

"The ultimate objective for the dollar is near ZERO." (5/09)

"I am 100 percent sure that the U.S. will go into hyperinflation [at rates] close to Zimbabwe's." [Zimbabwe's inflation rate reached 231 million percent in July, 2008.] (5/27)

"If they print enough money and the value of the US dollar collapses, then S&P could go to 50,000, Dow Jones can go to 1,00,000." (6/4)

"Many fear inflation right now amid government efforts to goose the economy. Universa's bet, however, is that inflation will reach levels few expect." [i.e. hyperinflation] (6/1)

The money supply is set to "explode" worldwide. The "longer-term trend is up" for emerging-market stocks, so "We continue to try to be as fully invested as possible in these markets." (6/4)

"I think what we're doing now will either fail, or it will result in unbelievably high inflation -- and tragically, maybe both. That would mean a depression and explosive inflation, which is frightening." (6/4)

"It's difficult to estimate the magnitude of the inflationary...consequences of the Fed's action. [W]hat's happened is potentially far more inflationary than were the monetary policies of the 1970s, when...gold prices went from $35 per ounce to $850 per ounce and the dollar collapsed on the foreign exchanges." (6/10)

"This will ultimately mean record inflation.... We have never seen a collapse of a currency like the dollar. Even the hyperinflation during Germany's Weimar Period can not serve as an example." (6/1)

"The Fed can of course print money to buy up every Treasury bond in existence, but the inflationary ramifications would be Zimbabwe like, and crush the dollar on international currency markets." (6/2)

These expressions are more extreme than those of March-July 2008, the last time the dollar was bottoming, just before commodities crashed.

Despite the impressive brain power behind some of these statements, I maintain the opposite opinion: that the world's financial system is in the early stages of the greatest deflation ever. Just before the March low in the stock market, we were able to call for a respite in the trend, so the calls for inflation that this rally has rekindled appear to us as a normal development. Investors typically fight the last war. Economic bears today are inflationists because they fear a bigger version of the 1970s. Paul Krugman (with whom I disagree on virtually everything) on May 29 quoted an economic historian on the sentiment of the early 1930s, when the inflationary 'teens were likewise burned into people's memories:

...during the early years of the Great Depression...many influential people were warning about inflation even as prices plunged. As the British economist Ralph Hawtrey wrote, "Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah's Flood." And he went on, "It is after depression and unemployment have subsided that inflation becomes dangerous."

The latter statement above is exactly what Conquer the Crash said:

While I can discern no obvious forces that would counteract deflation, after deflation is another matter. At the bottom, when there is little credit left to destroy, currency inflation, perhaps even hyperinflation, could well come into play.

Consider also that more inflation is the easiest call on the planet. The presumed forces of external causality are clear as can be: We all know that Bernanke is an inflationist. We can see that the Fed and other central banks are offering unlimited credit. We can see that the government is spending money at a record rate. And we know that nothing tangible backs the dollar. But simple logic based on external causes does not work in predicting financial markets. No one was predicting hyperinflation in 1999 and 2001, when the dollar was topping and the metals bottomed; on the contrary, at that time it was "obvious" that the Fed had the monetary system under control, there was a "New Economy," and stocks were the only smart investment. At the 2008 all-time highs in commodities, everyone knew the opposite: inflation had been soaring since 2001, the dollar was crashing, and it was "obvious" that the Fed was engineering a powerful inflation. That was right before commodities fell more in eight months than at any time in modern history. Many of the hyperinflationists quoted above are career contrarians, as I try to be; but a forecaster should be quite concerned about the true extent of his contrariness if the evidence for his being correct were cycling right along with that for the average (bullish) economist, which is exactly the position of today's believers in hyperinflation: Every time the markets rally, the opinions of both groups feel right. At EWI, the evidence for our being right in the current environment cycles contrarily to both camps. Markets are all about paradox. As Joe Granville so elegantly put it, "What is obvious is obviously wrong." Our job is not primarily to figure out what's wrong with the obvious case but merely to figure out when a case is so obvious that it is likely to fail. The inflation/hyperinflation case -- if only because of its popularity -- is highly likely to fail.

Nevertheless, I also continue to believe that the inflationary arguments are fundamentally wrong. That the Fed and the government are failing to bring back inflation seems quite evident to me. They worked overtime for a year and a half to force "liquidity" into the system, and the markets did not just fail to soar, did not just fail to hold up, did not just drift downward, but collapsed throughout that time. Now that a temporarily rising social mood has naturally led to some reflation, people think the Fed's machinations are "working." But long-term interest rates are rising to choke them off. The Fed announced a campaign to buy T-bonds to keep long term rates down, and those darned rates just won't cooperate! Sorry, but there is no free lunch. You can't beat deflation in a credit-based system.

The U.S. Dollar
As investment prices have risen, the dollar has fallen. These trends resulted from an expansion of credit, which in turn is the result of waxing optimism. Investors' views on the dollar have changed accordingly.

Last March, 93 percent of traders were bullish on the dollar, according to the Daily Sentiment Index (trade-futures.com). Now, just three months later, the June 2 reading shows only 6 percent bulls (94% bears), a round trip in sentiment. At the same time, traders love the other currencies, with recent readings of 93% bulls on the British pound (which Steve Hochberg featured on the Short Term Update last week), 95% bulls on the euro and 96% bulls on the Canadian dollar.

US Dollar Nearing a Bottom

Figure 2 shows that the U.S. dollar is approaching a major bottom. If the labeling shown in EWFF (placed here on the "Alt." line) is correct, the bottom has just occurred; if the main labeling shown here is correct, the dollar will bottom after one more rise (wave 4) and fall (wave 5). Either way, the next bull market in the dollar should be a powerhouse.

The dollar will rise not because it is healthy but because it is the sickest currency in the world. More debt is denominated in dollars than in any other currency. When this debt implodes to worthlessness, remaining dollars will go up. The key is to be in dollars that survive, which is the whole message of Conquer the Crash.