Hyperinflation or Prolonged Deflation? Coping and Investing Strategies For Either Scenario

by Millionaire Mommy Next Door on June 22, 2009

in Debt Reduction,Economy,Investing,Real Estate

Rebecca commented:

I enjoy these posts – thanks for adding a voice of reason given the vast propensity to imagine the solution to the problem is doing more of the thing that caused the problem. We’ve collectively been telling ourselves the same stories so long it’s hard to ram home still that they *are* just stories; it’s good to keep hearing stuff like this to remind us. Like Anna, I’d love to read your thoughts on surviving the possibility of heightened inflation over the coming years – its impact on savings and so on. I know you suggested in a previous post you were concerned with this matter. Any thoughts?

Many fear hyperinflation, but after digging into the topic, I don’t think it’s as likely a scenario as prolonged deflation. From what I’ve been hearing, talk of hyperinflation might be driven more by politics than economics.

We are experiencing deflation right now. Using the 12-month change in the Consumer Price Index as the measure, inflation has been negative for three consecutive months. I think the more likely scenario will be like Japan: low inflation, low interest rates, and falling house prices for at least a couple more years.

… Japan, during what came to be known as its “lost decade.” A gigantic real-estate boom in the 1980′s came crashing down in 1991, bringing many other prices with it. Efforts to restart the economy foundered time and again, as businesses were not able to generate the kind of profits that would reignite prosperity’s cycle of hiring and spending. Not until 2005 was the deflationary era finally declared to be over. ~ New York Times

Because I’ve been sitting on a considerable sum of cash since I made my exit from the stock market during the first half of 2008, I’ve been mulling over this topic. I’m still trying to wrap my head around the implications of hyperinflation and prolonged deflation. I am not an economist, so please take my thoughts and opinions with a grain of salt. In other words, this post is not investment advice; just my best guess and opinion.

During deflation, debt is the enemy. Deflation is better for those with savings accounts because it increases the value of the money they have saved. Deflation rewards people like me (with cash) and retired seniors (who no longer need to worry about rising unemployment rates and would benefit from living cost containment).

During hyperinflation, the last place one wants to be is in cash. Inflation is better for those who owe money because it reduces the value of the money previously borrowed. Inflation is better for those in debt — including the US Government. So naturally, the Fed wants to create and maintain a moderate, steady rate of inflation.

Many people worry that the amount of money the Fed is spending to stimulate the economy will create hyperinflation. I think these fears are unfounded, at least for now. Last I heard, the Fed created about a trillion dollars, which sounds enormous, but is actually small when compared to the approximately $10 trillion drop in housing values and ~$10 trillion drop in stock market capitalization.

The Fed realizes they need to be careful — if they dilute the economy with too many dollars, they risk creating hyperinflation. Hyperinflation would be tough on everyone, including the Government, because foreigners would stop lending money to the US — unless they were sufficiently rewarded for taking on the heightened risk of investing in dollars.

Compensating foreign investors for taking on inflation risk means raising interest rates. But increasing interest rates would push homebuyers and homeowners with adjustable mortgages right over the edge. Mortgage rates have increased recently and if they keep increasing, we should see home prices fall further. Prices fall as interest rates rise, because a given monthly payment covers a smaller mortgage at a higher interest rate. Collapsing property values simply are not synonymous with hyperinflation.

According to this recent article in the New York Times:

For the short term, investment experts agree, deflation is more probable, with unemployment still climbing and the economy still mired in a recession. There’s talk of green shoots, but most everyone agrees that an earnest recovery is a long way off.

No one knows for sure what is more likely to occur: prolonged deflation or hyperinflation; or when the economy might change course. So how can we prepare for either scenario?

If you think hyperinflation is likely, you could invest in:

  • shorter-term fixed-income investments
  • TIPS (Treasury Inflation-Protected Securities)
  • foreign stocks and currency
  • real estate, REITS (real estate investment trusts)
  • commodities
  • precious metals
  • gold

During hyperinflation, the last place one wants to be is in cash.

If you think deflation is likely, you could:

  • raise and hoard your cash.
  • live below your means.
  • put off big purchases until prices drop more. You are, in essence, actively making money just by not losing it.
  • rent a home rather than own because home prices, like other hard assets, will continue to drop in value during deflationary times.
  • de-leverage yourself: pay off your credit debt as soon as possible — and don’t start building it up again. You don’t want your debt to expand at the same time dollars are becoming more valuable!
  • invest in dividend paying stocks. But it can be tricky to find a secure dividend paying stock in a deflationary environment.
  • play the currency market (certainly not my area of expertise).
  • play the short side using things like inverse index funds that move in the opposite direction of the market. Caution: While there are possibilities for making huge returns in this market, the rallies in a bear market can whomp you. Your timing must be precise.
  • build a CD ladder. The longer the duration the more risk there is, but at least your principal is protected.
  • invest in yourself and your education. Staying employed in such a downturn is the most important thing.

During deflation, debt is the enemy.

What am I doing? What do I plan to do?

Over the course of the past few years, I have positioned myself as best I can for the current economic deflation: I sold my home, paid off all of our debt, pulled out of equities and hoarded cash.  Today I am in a wait-and-see holding pattern and once deflation is curbed, I am in a great position to change course accordingly: I have cash ready to buy the hard assets (when they are cheap) that will help me weather inflation.

What about you? Do you think prolonged deflation or looming hyperinflation is more likely? Why?

{ 17 comments… read them below or add one }

derek June 23, 2009 at 12:38 am

Stagflation or Japan is what i think. Your bang on.

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Akemi - Yes to Me June 23, 2009 at 11:28 am

Between the two, I think deflation is likely. (And as a Japanese, I can assure it’s not as bad as it sounds.)
However, I see a bigger picture. I think this is just the beginning of huge change in the economy / our way of life.
In the (possibly near) future, I think most living necessities are produced and consumed locally, like at farmers market, basically by cash or quasi cash. Only special products and services will be worth for the long travel, and services that can be done over the internet will flourish.
I also think more people will be self employed. Partly because big business like WalMart crash and partly because we become more aware of our inner power.

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Debbie June 23, 2009 at 6:15 pm

I agree with Derek and Akemi – think deflation is more likely. The pendulum always seems to have to swing hard in the opposite direction to balance out what has been proceeding for years through out time. Basically living the high life and way beyond one’s means as a whole society for a long time. It was only time till it had to swing back. On the plus side people in general seem very focused on saving more now, paying off debt and not creating debt and business are actually analyzing people to see if they are a good credit risk. On the plus side for health, people are eating at home more and fixing their meals from stratch to save money which means they are becoming more healthier which means less money spent on medical bills in the future. Plus people are spending more quality time with their families as they cut back on items like cable, professional sport’s games, etc.

Now keeping up with the Jones means cash savings, little to no debt and paying off one’s mortgage early.

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Chewie June 23, 2009 at 8:29 pm

From what I’ve been reading, one of the dangers of inflation is that it’s a bit self-fulfilling, so while we will probably see some deflation in the next 2-3 years, I expect to see higher inflation in the following 5-10 years for these reasons:
1.) partly because everyone expects it.
2.) The government may try to “inflate” it’s way out of the deficit mess
3.) We are pretty far in debt as a nation, so it’s hard to imagine that it’s going to turn out good for our currency anytime soon.

One word of caution on investing in REIT’s during hyper-inflation… usually hyper-inflation is accompanied by a drop in economic activity. Since most REIT’s invest in commercial property, they may not be the safest hedge under those conditions.

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Jan June 24, 2009 at 5:25 pm

“The way a reserve currency nation gets out from under the burden of excessive liabilities is to inflate, devalue, and tax.” — Bill Gross

Nobody really knows what’s going to happen but for the time being my bet is on a bout of deflation followed by strong inflation.

Many “gurus” think inflation will return after a while (LEAP/Europe2020: by the end of the summer – in Europe, Schutte: end of 2009, Gleason: early 2010)…
Also warning for inflation are Faber, Buffett, Rogers…
Nobody really knows and these “guru’s” could well be wrong.
But governments NEED inflation and are likely to try to make it return. Chances are they won’t be able to control it and high inflation might occur. I’m not betting the farm on it but will use part of my portfolio to protect against this.

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traineeinvestor June 25, 2009 at 1:30 am

I’m something of an agnostic on the subject with a bias to the inflation camp in the longer term. At the moment the deflationary forces of deleveraging, reduced consumer spending, higher savings rates and (in some places) higher taxes are prevailing over the inflationary forces of fiscal spending sprees, (in some places) lower taxes and lower interest rates. However, as others have pointed out, governments need inflation as there is little possibility of repaying their debt burdens without it.

My own investments are somewhat balanced between strategies which will do well if inflation rises and will not suffer too much if deflation continues. As examples, I have kept our real estate investments but kept the debt at a level where the rent meets not only the P+I mortgage payments but also the other outgoings. Our other investments are spread accross a number of funds, equities, bonds, commodities and structured products in the quest to get a better return than the 0.0001% which Hong Kong banks pay on call deposits.

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Chad @ Sentient Money June 26, 2009 at 3:09 pm

I’m on the side of a japan style delationary period, but shorter time frame (2-3 years) and milder deflation. The govt will definitely try for an inflationary period, but will miss it initially. The miss will be because we still have more pain ahead. They will then have to keep the current inflationary policies for an extended period of time. This will cause a whipsaw movement making it very difficult to make the right call over the next 4-5 years, as the change will probably be rapid. I’m not holding anything long right now. Though, I anticipate going long commodities at some point.

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ElizabethG June 28, 2009 at 10:51 pm

I’m in the inflationary camp, and have positioned with foreign equities, but no real estate. I have been blogging about this:

Investing for Inflation

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Scott E. Vines July 13, 2009 at 1:39 am

We will have one more round of disinflation (reduction in the rate of inflation), followed by severe inflation that will turn into hyperinflation if the federal government doesn’t immediately reduce its spending. Everyone is talking about deflation, but we haven’t had any because the inflation rate has not dropped below zero. During a depression, which we’re in if you use pre-Clinton-era formulas, deflation is the norm. However, we’re inflating the money supply at an astronomical rate (and the Fed is lying about it). This will lead to a currency crisis, a devaluation of the dollar, and the unfortunate and seemingly paradoxical combination of high unemployment and higher prices for most goods. Worst of both worlds…. But you idiots asked for it. You elected socialist, both Democratic and Republican, and now you will reap the whirlwind.

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MoneyEnergy August 13, 2009 at 1:12 am

The problem I see though is the way that CPI numbers are calculated. Why don’t they include the costs of energy and food? Those are the two essential components of living costs and would give a more accurate picture of inflation vs. deflation.

Of course, inflation doesn’t mean “good economy” and deflation “bad” or “dropping” economy. According to strict definitions, inflation is the measure of the money supply, which has already been inflated to the yazoos. Part of it isn’t showing up at all on the radar yet because of the huge amounts of excess reserves now held at banks (the Fed this year pulled a new trick out of its hat and began paying banks to keep these reserves rather than lend them out). So there’s a whole lot of cash that “exists” yet is not really “in the market” yet. It’s good for banks to finally have reserves. But I’m waiting in part to see when the excess starts flowing out again – perhaps once the economic situation stabilizes (homes, jobs, production).

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Bob B October 13, 2009 at 9:05 pm

The most evil tax increase is the government inflating the economy!
ps I dont believe we are in deflation, as I shop a lot at walmart and over the last year, prices have gone up big time.

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Louis C December 5, 2009 at 3:58 pm

I think deflation is the more likely scenario. Tax revenues are falling, housing values are falling, and unemployment remains high. For now, governments continue to take on debt to continue spending. This is ordinarily inflationary; trouble is, all major economies are doing the same thing. Gold prices are increasing not from inflation expectations, but from the economic reality: all major economies are devaluing their currencies.

Interest rates have to be kept low in order for all of these countries to service the enormous debt loads; until excess capacities in both housing and industry are ‘worked off,’ hyper-inflation is unlikely.

It doesn’t matter how much reserves the Fed tries to inject into the banking system. If there is no demand for borrowing – that is, no demand spurring investment and spending, there is no demand for money, so interest rates will hover close to zero until the ‘excesses’ are worked off. I think the Japan scenario is precisely going to happen, only on a global scale.

My thinking is this:

Cash is king. Limit stock holdings to dividend-paying consumer staples and utilities, limit or eliminate mortgage debt and eliminate all other borrowing. Put a limited part of your capital in mutual funds/ETFs that are short the stock market, and hold a limited amount in gold or other precious metals. Put your cash in T-bills and possible diversify into short-term Government notes denominated in other currencies.

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garlic 71 January 21, 2010 at 8:41 pm

State, local governments and the Fed are broke. Public pensions have bankrupted this country. As I see it, the only way for the country to keep from going bankrupt ( yes, many authorities say so) is to have hyperinflation. In this way , the governments survive . Otherwise, with deflation, by 2020 the USA is kaput.

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Mule Skinner February 15, 2010 at 3:02 pm

Wouldn’t gold also serve during deflation? Of course the number of dollars per ounce will decrease, but the purchasing power per ounce should hold steady.

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Bruce Norris April 26, 2010 at 12:43 am

I agree with the deflation camp. My company buys and sells property in California. With unemployment very high and mortgage delinquencies at all time records, who will be buying the millions of vacant homes nationally that are about to occur? Investors can’t get financing, so you are stuck selling houses to the all cash buyers at below replacement cost or first time buyers who buy entry level housing. {50% of the market is first time buyers and another 20% are all cash buyers in California.} In the past 12 months mortgage delinquencies have doubled in California while foreclosures have been cut in half!? The banks are often not even beginning the foreclosure process on people, allowing them to get 12-24 months behind before filing the foreclosure. In addition, what is about to occur in Southern California is an avalanche of homes being foreclosed on by lenders where the mortgage exceeds 1 million dollars. In Riverside County alone, there are about 2,900 3,000 square foot homes or larger scheduled for the court house steps in the next 60 days! You are about to have the most fantastic houses in our area sell for $125.00 a foot. {Try to repalce a 6,000 square foot custom home on an acre fully decked out for $750,000}. This puts pressure on the 4,000 square foot house etc. The lots in these areas used to sell for $600,000 or more. Every week over 100 million dollars of land loans go through the trustee sale process without any bidders. The lenders who lent all of this money are temporarily holding something that today is usually absolutely worthless.
I don’t see how California makes an economic comeback with the building industry unable to compete with the existing price structure for housing. No building, no improvement in unemployment, no improvment in unemployment, no migration back to California. No migration back to California, no excess demand for real estate. No excess demand for real estate, no upward pressure on prices.

In some cities in Riverside and San Bernardino Counties, 60% of the owners are upside down. If prices do not rise soon enough, more of these owners will walk away and do a strategic default. This would cascade even more inventory into the banks and create an even lower pricing structure.

The California market is beginning to give signs of improvement, but this has occurred only because of a shortage of inventory. That shortage of inventory isn’t real and could change at the drop of a hat {or the next government policy change}.

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Ernest June 5, 2010 at 3:26 pm

I’m counting on long term deflation, but prepared for inflation as well. Right now I have a lot of money in TIPS (Treasury Inflation Protected Securities) which rise with the CPI in inflation, and hold face, or par, value in deflation. However, I am looking at other income sources that I never considered. For example: A local credit union is paying 4.51% interest on a maximum of $25,000 high yield checking. That is an extra $1,100/year for an account which is liquid and guartanteed. Stuff like that. You have to shop around, but it beats working! Meanwhile, I continue a very low cost lifestyle. My wife and I enjoy beach walks, which are free, unless you live in most of the country where that is what you do on an expensive vacation. So it is all relative.

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bubba pol July 22, 2011 at 2:31 pm

about Walmart

During a deflationary cycle (which we are in, just look at the housing market) all govts try to “pump” their way out of it. It is not working, as the pump is only used as a “trigger”…to trigger the consumer to let go of what they have. After all the housing market has lost trillions, and the pump has not inserted anything equal to that.

The reason why food and gas go up during govt “pumping” during deflation is that those goods are places for that money to safely go. The rest sits quitely at the banks (or on their computers)

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