So Which Is It, Inflation or Deflation?

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Wise investors say, “The return of your capital is more important the return on capital.” At least that is one of Warren Buffett’s maxims. The point is that if you do not understand an investment, its dynamics, its risks and its potential rewards, then you shouldn’t invest in it. You want to be confident that you will get your money back. You don’t want to gamble.

Understanding what is really happening to prices is the key to not losing any more of your capital in the current environment. Many of us have lost substantial amounts in the past year, in spite of the stock market rally. And we don’t want to lose any more.

Let’s say we are playing it safe and all of our savings is out of the stock market and in a money market account. If inflation is higher than the return you are earning, then your capital or savings is decreasing in value. On the other hand, if inflation is negative and you are earning 0% on a money market account, then the real value of your savings is increasing.

If we are playing it safe in this time of uncertainty and inflation is high, then we are becoming poorer. This is important because many observers expect the US and perhaps the world to go through a period of high inflation thanks to government money printing. Some notable hedge fund managers have made huge bets on gold and gold mining stocks, adding large amounts of GLD and GDX to their portfolio to hedge against high inflation going forward.

As I’ve mentioned several times in my previous posts, while this is an appealing argument, right now it still seems that deflation may be winning out.

Bryan Rich, the Weiss Research currency analyst, makes an interesting argument in his recent weekly newsletter that real interest rates in the US are actually among the highest in the world (the real interest rate is is approximately the nominal interest rate minus the inflation rate). His argument is that interest rates may not be low enough to stimulate inflation and thus deflation will win out. Citing Goldman Sachs, he notes that the U.S. needs short-term interest rates of -6% just to keep the rate of inflation positive. He also argues that prices are falling in over half of the world’s largest countries with some reporting the biggest price drops on record and others their first price declines since World War II.

One can argue, and many do, that the statistics are rigged and that inflation is actually higher than what is being reported in offical statistics. Nonetheless, if Rich’s argument is true, then having our money parked in a short-term money market account sitting out the current volatility isn’t a bad thing. And if it’s true that real interest rates are among the highest in the world in the US, then the dollar should rise in value.

Not a bad outcome for doing nothing.

We’ll keep monitoring this debate because it holds the clue as to how to allocate our long-term investment capital.