The document discusses whether the current economic environment is more likely to lead to inflation or deflation. It analyzes factors influencing the debate such as declining asset prices, falling consumer demand, and aggressive monetary stimulus by central banks. While central banks have taken inflationary actions, the document concludes deflation remains the greater threat due to continued weakness in the banking system, low consumer spending, and lack of signs of rising inflation. The environment favors bonds over stocks and commodities in the near term until the banking system shows more stability.

1. THE INFLATION-DEFLATION DEBATE
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There has been much discussion in the media and amongst
investment professionals over whether we are in the grips of
a 1930’s style deflationary spiral or if central banks are
creating the potential for hyper-inflation with their efforts to
avoid a banking system collapse. It is important to
determine on which side of the price stability graph we are
likely to be in the coming months because there is a
marked difference in the performance of the various asset
classes under each scenario.
In general, commodities and hard assets perform best in an
inflationary environment, bonds and money-market
instruments perform best in a deflationary environment and
stocks perform best in an environment of price stability.
In this edition I will attempt to identify some of the factors
influencing the debate and determine which scenario we
are most likely to encounter in coming months.
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Following the oil price shocks of the 1970’s the western economies have largely been in a
disinflationary period from the 1980’s through to the present day. This era of price stability co-
incided with one of the greatest bull markets of all time. Despite massive wealth creation and
large increases in the prices of real estate and commodities, central banks kept interest rates
relatively low as inflation, measured by CPI, has been rather benign. Low interest rates and easy
credit created an environment ripe for risk-taking and speculative activity which lead to a number
of asset bubbles. One of the criticisms of this era is that central banks were focussed on inflation
expectations in consumer prices and largely ignored the inflation developing in the various asset
classes. This focus went into reverse whenever there was a significant correction in asset prices as
fears of a negative wealth effect trumped inflation expectations in consumer prices. The
“Greenspan Put”, as it became known after Fed Chairman Alan Greenspan, continued to provide
a stimulus to wealth creation and speculative activity with little expected downside risk.
The speculative fever reached its zenith in 2005 when, thanks to a combination of greed and
financial alchemy, those who had previously no hope of obtaining credit suddenly found
themselves living the American dream. I say “American dream” because the catalyst to this crisis
really started in the sub-prime real estate market in the U.S.A. This dream slowly turned into a
nightmare from 2006 and continued to simmer until a combination of factors converged to crisis
proportions in 2008. Inflation fears in early 2008 gave way to actual deflation in late 2008. To be
certain, there was deflation in the U.S. real estate market as early as 2006 which crept into the
stock market in 2007 and commodities in 2008. As each asset class entered a deflationary trend it
has remained in that state to the present day. Brief rallies were quickly snuffed out.
Inflation as measured by CPI was never much above 2% since the early 1980’s despite the massive
increase in real estate, stock and commodity prices. I believe much of this price stability can be
attributed to improved productivity and globalisation. Far from exporting inflation, the emerging
economies, through their lower labour costs, created an environment of price stability which was
further supported by the economic efficiencies created through globalisation. However,
globalisation also created greater dependency and integration which helped act as a catalyst to
the crisis. The East exported cheap goods and the West exported cheap services!

3. March 2009
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In the past 25 years central bankers around the world shifted their focus from money supply growth
to inflation targets to both measure and control inflation expectations. This worked well during
periods of relative price stability. However, given the difficulty in measuring the various monetary
aggregates and the focus on CPI targets, inflation was created in asset prices through easy credit.
While the positive wealth effect did not materially influence CPI during the boom years, inflation
expectations have rapidly reduced with the negative wealth effect from collapsing asset prices.
This is probably best explained by the debt-deflation process described by Irving Fisher and
experienced during the Great Depression. Money Supply focus is now back in vogue. As the
graph below illustrates, a rise in CPI tends to lag a combined rise in money supply and credit.
During the Great Depression all three contracted at the same time creating a deflationary spiral
and exacerbating both the length and breadth of the downturn. A massive increase in the money
supply is now necessary (as both CPI and credit are contracting) to avoid a deflationary spiral.
This would only be inflationary if credit was expanding at the same time and demand was falling.
The money supply, credit and inflation link
-5%
0%
5%
10%
15%
20%
25%
Jan-60 Jan-66 Jan-72 Jan-78 Jan-84 Jan-90 Jan-96 Jan-02 Jan-08
M2 Consumer credit CPI
Western economies are largely flexible and this allows for a dynamic process that adjusts variables
like wages, capital costs, employment etc. Normally, this dynamic process allows for a reasonably
quick adjustment keeping recessions mild and relatively short-lived. However, the one variable
that tends to be inflexible to the adjustment process is debt. As asset prices collapse leverage
automatically increases and this causes a chain-reaction of further asset sales that depress prices
still further in a process that feeds back on itself. The removal of credit due to the re-discovery of
risk reduces the money supply (velocity of money) and an attempt to stimulate growth with
inflation targets and interest rates is met with a muted response. Governments must increase the
money supply manually if credit is withdrawn or accept a significantly smaller demand for
goods/services in the economy. The fear of an inflationary spiral caused by Governments printing
money is only relevant if there is evidence of cost-push or demand-pull factors in the economy. At
the time of writing there are no cost-push factors that would indicate the emergence of
inflationary pressures. The costs of materials and labour are exhibiting more deflationary
characteristics. Asset prices continue to exhibit deflationary characteristics as well. Consumers are
not bidding up the prices of goods and services, quite the opposite, hence no demand-pull
pressures either. Therefore, there are no signs of inflationary pressures. This is further exemplified by
the graph below which shows actual CPI and inflation expectations (as measured by 10y US TIPS)
collapsing in dramatic fashion. In fact, both are exhibiting signs of deflation and this is more
worrying against a record spike in the TED spread (a measure of global financial risk expectations).
More recently, the chart indicates a slow return to normal levels. It may be too early to say that
this “normalisation” process is sustainable but for now it looks as if the “shock” is over.

4. March 2009
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10y US TIPS breakeven rate, actual CPI and TED spread
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
Expected inflation over next 10y Actual CPI TED spread
The authorities made many mistakes during the Great Depression that exacerbated the downturn.
There was little knowledge of the effective uses of both fiscal and monetary policies needed to
stimulate demand and stop the deflationary spiral. Even with today’s knowledge it is difficult to
stimulate demand if the banks won’t lend and credit is not available. Despite aggressive
monetary stimulus in the form of interest rate reductions we see no real increase in borrowing. As
the following graph shows, Real rates were briefly below zero but have since risen as CPI turned
negative. Monetary authorities have virtually exhausted this form of stimulus and even zero rates of
interest have failed to reduce real rates when CPI turns negative as Japan has discovered in the
past 15 years. Consumers and businesses are more likely to focus on repairing their balance
sheets than stimulating growth through consumption and investment.
Implied and actual real rates
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
Implied real rate Actual real rate
Inflation expectations have slowly normalised as the following graph shows. Points below zero on
the graph indicate an inverted yield curve which implies lower inflation expectations. Points
above zero are indicative of a “normalised” yield curve. The shape of the yield curve has been
volatile of late and was factoring in a deflationary risk. However, despite “normalising” in the past
few weeks it is not indicating a high risk of inflation.

5. March 2009
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Spread 10y 2y T-Note
07/04/2000, -0.51%
15/07/1992, 2.68% 29/07/2003, 2.74% 13/11/2008, 2.62%
26/12/2008, 1.25%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08
Authorities are now discussing “Quantitative Easing” as a form of increasing the money supply
through direct purchases of assets for cash. There are those who think that this will lead to inflation.
However, savings rates in the U.S. are rising as consumer behaviour is forced to change. The large
level of debt accumulated by the U.S. Government during its bailout program and other forms of
fiscal stimulus can eventually be financed by the savings of U.S. consumers as well as sovereign
funds. This is not necessarily bad for the U.S.$ nor is it inflationary. There may be an incentive to
monetise the debt at some point but this need not be an immediate concern.
The gold price is often seen as an inflation barometer, partly because it is inversely correlated to
the U.S.$. The gold price has recently broken out of a downturn that began as the crisis unfolded
last summer. Gold did not benefit from a flight-to-quality as much as the U.S.$ did. In fact, despite
the perceived weaker fundamentals of the U.S.$ it still was best in show relative to other currencies.
Some people assume that gold’s recent rally is indicative of rising inflation expectations but gold
has risen along with the U.S.$ which is a little bit unusual. Demand for gold is not coming from
traditional sources such as jewellery and countries like India. Instead it is rising by increased
speculation and coinage demand. Apparently while the rest of the world is buying U.S. T-Bills,
Americans are loading up on Spam, guns and bullion in preparation for Armageddon.* Once
again, this is not an indication of a rise in inflation fears. As the previous graph shows there is a

6. March 2009
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long-term cyclical relationship between gold prices and the stock market (represented here by
the DJIA). The relationship is particularly revealing during significant changes in inflation/deflation
expectations. There are three distinct periods represented in this graph. The first co-incides with
the Great Depression of the 1930’s which as we know was a deflationary period. The second
period co-incides with the inflationary era of the 1970’s following the oil price shock. We are now
in another period that is similar to the 1930’s. What is more notable is the time frame involved from
peak-to-trough. The graph clearly shows that gold has out-performed the stock market since the
early part of this decade. It is impossible to know how much longer this out-performance will last
exactly but it does look as if the majority of the move has already taken place. We are likely in the
final stages of this cycle which would imply that the gold price has limited upside from here in
relation to the stock market. Of course, the relationship would still hold even if gold prices did not
move higher and the stock market continued to fall. My best guess is that is exactly what will
happen. Once the banking system stabilizes we could see a reversal of this relationship but
previous cycles do not imply a major reversal.
CONCLUSION
It seems evident that there are few signs of an inflationary spiral taking hold. Talk of hyper-inflation
is premature at the very least. While central banks and governments are using a combination of
fiscal and monetary stimulus there are no signs that these measures are stoking inflation. In fact,
asset prices and CPI still have a deflationary bias despite some evidence of stability returning to
prices. Banks and consumers have changed their behaviour. It seems unlikely consumers will
leverage up and go on buying binges anytime soon even if they could find a bank to lend to
them. Lending standards have tightened up dramatically and even if they loosen up are unlikely
to return to pre-crisis levels for quite some time.
As we mentioned in our previous edition we need to observe stability in the banking system before
the first stage of this crisis is over. The immediate threat is still deflation and this may be followed by
a period of price stability before we have to concern ourselves with an inflationary spiral. As the
graph on page 2 illustrates deflation was a consistent threat for more than a decade in the 1930’s.
There were brief periods of price rises but these were not the makings of an inflationary spiral. The
only threat of an inflationary spiral came following WWII when there was an attempt to monetize
government debt. There may be an incentive for governments to monetize the debt built up
during the current bank bailouts but we are probably some years away from this. As long as
governments continue to contemplate nationalising banks then the crisis is not over and deflation
remains a bigger threat than inflation.
As mentioned in our previous edition, we are monitoring U.S. Corporate/Government bond yield
spreads as a leading indicator for a sustainable recovery in the stock market. Once the banking
system stabilizes then a compression in spreads will indicate a reduction in risk aversion. We would
expect the stock market to be attractive at this time. We are not quite there yet. The current
environment still favors bonds over stocks and equities over commodities. Within the stock market,
the larger, liquid value-type stocks are likely to lead the recovery. One must be very selective
within the smallcap space. We refer the reader to our recent “Beating The Bears” note which
highlights our strict filtering process to identify our top-picks within the smallcap space.
* Bloomberg news February 27, 2009

7. March 2009
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