Saturday, March 21, 2009

Inflation or Deflation?: A firestorm of debate erupts


Last Monday I wrote about the possibility that the US Federal Reserve was opening Pandora's box and unleashing a destructive wave of monetary inflation with their policy moves to deal with the financial crisis.

Through programs known as quantitative easing, the Fed was basically printing money in an attempt to buy up toxic assets.

On Wednesday March 18th, Fed Chairman Ben Bernanke raised the ante with a move that has shocked the financial community. In announcing that they were printing an additional $1 Trillion dollars, the Fed embarked on a course that has NEVER been utilized... they began buying their own treasury bills.

This has touched off a firestorm of debate around the world as to whether it is deflation or inflation that looms on the horizon.

But who is right?

In the Vancouver Sun the debate is hi-lighted in an article titled "Will it be inflation or deflation? Observers are split: U.S. government's injection of new money could overheat the world's biggest economy".

"That's one of the great debates right now," said Douglas Porter, deputy chief economist at BMO Capital Markets. "What is the greater medium-term risk to the global economy -- deflation or an outbreak of inflation?"

Yesterday I wrote that Garth Turner had come out decidedly against the inflation scenario. Today he has somewhat tempered his outlook. In the latest post on his blog, Turner concedes the point I have been trying to make - that the policies of today will lead to an inflationary spiral that contains a poison pill for anyone buying real estate in today's markets.

While Turner envisions a longer time-line, the end result is the same. Dramatically higher interest rates are on the horizon. Anyone buying now and financing at today's incredibly low mortgages rates face a devestating prospect.

The normal fixed-rate mortgage term here is five years, and increasingly borrowers have opted for shorter periods of time, gambling that interest rates will be lower when the loan comes due.

But as Turner notes, "Rates can only move in one direction. Up. Over the course of the next five years, possibly way up. In fact, I’d say it’s a certainty. Central banks around the world have been printing a flood of money to try and stall deflation and revive economic growth. Public debt has exploded, governments have plunged headlong into deficit spending, countries are buying back their own bonds with tax money and banks have been nationalized while the money supply increases. In this are sown the seeds of inflation, once economic expansion continues."

Turner then summarizes the looming catastrophe, "So, if 3% mortgages in 2009 become 11% mortgages in 2014 (that is the historic norm over the last few decades), just imagine the consequences for someone buying a house today. After all, a $400,000 mortgage at 3% costs less than $1,900 a month to carry. But the same loan at 11% has double the payments - $3,850 a month."

The inflation vs deflation debate rages on right now. But even staunch inflation discounters like Garth Turner now concede that dark storm clouds loom on the horizon, storm clouds that could bring economic ruin to anyone holding a large mortgage or who jumps into the market with a large home purchase.

Check out this CNBC roundtable debate on the issue featuring Peter Schiff. Its a complex issue but it is imperative that everyone understand what is going on.

Tomorrow I will try to post a summary outlining Schiff's position.



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