Boiling Point: Inflation + Deflation = Trouble

November 19, 2010

Who would have thought the Fed would have to fight inflation and deflation at the same time?

Get ready for both inflation and deflation in the coming years. The deflation will come from assets that are dependent on credit creation, most notably housing, and the inflation will be on materials that come out of the ground, such as oil and copper, the stuff the world runs on and is made of.

Chadd BennettMoody's is predicting an average decline in U.S. housing prices in 2011 of 7-10 percent. The problem is the number of distressed properties coming onto the market combined with tightening lending standards. Both factors will keep prices falling.

You’d think that rising prices of raw materials like lumber might be enough to increase the intrinsic value of homes in order to offset these head winds, but you’d be wrong. The combination of higher mortgage rates, oversupply and regulatory/legal factors will likely more than offset the rise in prices of materials that are needed to build a house. The demand for homes just isn’t there right now.

What Wealth Effect?

Jeremy Grantham recently argued in a CNBC interview that falling housing prices are complicating the Fed’s ability to create the wealth effect. Academics say that the improvement in sentiment associated with rising equities translates to about a $240 billion annual boost to consumption for every $1 trillion increase in stock market capitalization.

Cross-referencing some of the U.S. Treasury’s Flow of Funds data, it seems fair to conclude that a more than 5 percent decline in housing prices would more than offset any positive wealth effect caused by stock market appreciation.

I’ve argued in this column that the Federal Reserve’s “quantitative easing” program—so-called QE2—will not achieve sustainable economic progress in the form of "full employment" and “stable prices.”

The plan is clearly weakening the dollar, and between the solid demand pull for materials from expanding countries like China, prices of all sorts of commodities, such as cotton, are spiking.

Take the iPath Dow Jones-UBS Cotton Subindex Total Return ETN (NYSEArca: BAL). It has doubled in price in the past year and risen more than 80 percent in the past six months, as cotton climbs to highs not reached since the Civil War.

Considering sharply rising expenses like that, you can understand why the U.S. Bureau of Labor’s statistics on income and expenses paints a sobering picture that amounts to the opposite of the wealth effect.

Let’s say overall inflation of clothing, food and transportation increases by 30 percent, while your rent and income level stayed the same. What would that look like?

The quick and dirty math suggests that the bottom 40 percent of the country, by income bracket, would be spending more on necessities than they are making in after-tax income.

That would mean that nearly half of the country would need some sort of government assistance. So as the government and Fed try to inflate our way out of indebtedness, the social costs of economic policies will rise dramatically. The picture gets even gloomier when you add increased interest expenses on all the debt that will come as inflation causes bond yields to rise.

Don’t Hold Your Breath

Its not much of a stretch to assume that the same bottom 40 percent also made up many of the borrowers that were considered subprime and Alt-A.

Subprime and Alt-A represented anywhere from 30-40 percent of new mortgage origination between 2005-2006, according to some estimates. That compares with 10-15 percent in the 2002-2003 period. That leaves us with one troubling question: If the increase in commodity prices ends up destroying nearly half of the country’s financial means, how can we ever get demand for housing back to levels seen in 2004-2007? The answer is, don’t hold your breath.

The upside to this seemingly no-win situation is, ironically, that many people are already plenty pessimistic about the economic circumstances we find ourselves in. What I mean is that that people who save, and who at present are being punished via low interest rates, can find some bargains in housing. While I’m bearish on median house prices overall, I’m not ignoring the opportunity that distressed sales at extreme discounts represent.

Chadd Bennett is a trader and former financial adviser specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney.

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