Forecast: 2 Years of Deflation, Followed by Raging Inflation

I'm calling 1 1/2 to 2 years of deflation, followed by raging inflation.

Deflation Now

Richard Berner of Morgan Stanley, said: “A global recession is now under way, and risks are still pointed to the downside for commodity prices and earnings.”

Nouriel Roubini writes: "There is a glut and excess capacity of goods while aggregate demand is falling soon enough we will start to worry about deflation, debt deflation, liquidity traps . . . ."

And an oxford professor of economics and expert on U.S. inflation thinks deflation is probably on the way.

As Dan Denning writes:

So far, it looks like the deleveraging of the global financial system is destroying wealth faster than central banks can create new credit to replace it. [My comment: it wasn't real money, only "cotton candy".]

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[The trillions being spent on bailouts worldwide] small compared to the amount of value already destroyed in the residential real estate market and in the stock market. Twenty trillion has already been wiped off global shares. Property markets in the UK and the US are imploding.

So what we may have underestimated is how quickly this deleveraging and value destruction would spread to the commodity markets, which we thought would provide relative safety with the backing of tangible value. Resource stocks did not hold up for long at all. Why not?

On the one hand, it now looks like a lot of investors were buying commodities – and staying "long" of the trend – with borrowed money. Those investments have now been sold to raise cash and pay back loans.

Secondly, when it's a bear market in stocks, there aren't too many stocks that do well, full stop. Not even Gold Miners against the backdrop of gold bullion holding up well...or at least, not collapsing alongside everything else.

According to Bloomberg, people are not buying even though things are being sold at "Armageddon" prices.

Big investors are also hoarding cash. A report by JP Morgan shows:

"Markets are reflecting extreme levels of caution among investors. Institutional cash positions are close to their all-time highs."

Banks will keep on hoarding cash.

The Deutsche analysts don't see a bottom occurring until 2010. A recovery won’t occur until further beyond that: “unlikely in the foreseeable future”.

Inflation Later

But eventually, inflation will kick in. You've heard successful investors like Warren Buffet and Jim Rogers warn of inflation.

Well, the smart analysts I have been listening to are forecasting 1 1/2 to 2 years of deflation, followed by raging inflation.

Denning gives a possible scenario for how it is likely to play out:

If governments borrow to finance these various programs, they'll issue new bonds. Bonds soak up the available pool of global savings. To that extent, this new borrowing crowds out other ventures, which might otherwise have put the savings to a productive use. But financing the scheme with bonds is not, at least, right away, inflationary. Not in itself.

However, if governments can't find takers for the bonds they issue to finance these schemes, they will have to either raise taxes (not likely in a recession) or simply print the money.

And here's a hint. That's what they always do, from Argentina to Zimbabwe.

That is why we maintain the preferred response to huge debt levels is outright money-printing. Besides, simply making credit more available by lowering interest rates stops working after awhile (like when you can't lower rates any further...and become zero bound). How do you get available credit out of bank computers and into consumer wallets? It's not easy. Bankers are suddenly quite shy where they were once promiscuous.

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Right now, all this government cash is simply shoring up bank balance sheets with more capital. But to really "get things going again" and "fight the recession", the money will have to get back into the real economy. And this is where we see the inflation coming. Not in asset prices for houses or shares. But in real goods. Why?

If the government engages in massive public works projects as a way of stimulating demand in the economy and keeping up growth, it's going to be resource intensive. In a way, this is just another kind of phony boom, but with the free-market varnish stripped off to reveal it as an über-lending program by some kind of pan-governmental agreement worldwide.

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Western governments are already suggesting a system where the world's top thirty banks will operate under the supervision of a government panel of some sort. You'll see more "super banks" and greater control of the levers of global banking too, plus a concerted program to flood the world with new fiat currency.

Of course, the deflationary phase could be shorter or longer, depending on what the government does.

And remember that we might very well get simultaneous inflation in some asset classes and deflation in others.

Caveat: I am not an investment advisor and this should not be taken as investment advice.