Farr: Inflation versus Deflation

Over the past few weeks, there has been a revival of the debate about the possibility of a Japanese-style deflation in the US.

The fears were most pronounced two weeks ago when the major stock indicesshed 5+% in a week's time and investors poured money into the safety of US Treasuries(taking the yield on the 10-year Treasury below 3%).

There have been several such "flights to quality" during the course of the past 2-3 years since the financial crisis began. During these short periods of panic, investors typically sell all risky assets and buy whatever is safest, which is US Treasuries.

However, there has been one notable exception: gold.

Gold coins and bar
Gazimal | Iconica | Getty Images
Gold coins and bar

Gold, which is typically a preferred hedge against inflation, has soared and remains near its highs as many investors fear the inevitable result of such government largesse - inflation.

So are the gold bugs right or should we worry about the possibility of a lost decade of deflation?

Here is where I stand.

The bond market may indeed be warning us of the possibility of deflation going forward, and I certainly would not rule it out.

However, the more likely reasons for the recent sharp drop in Treasury bond yields (and also the strength in the dollar) are 1) the flight to quality resulting from the European debt crisis, and 2) the realization that the US is not experiencing a strong, V-shaped recovery.

In our view, this flight to quality to Treasuries (and other dollar-denominated securities) has been quite fortuitous for the US as it has reduced our cost of money across the economy at a critical time.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

Lower interest rates have undoubtedly been very helpful in generating economic activity and supporting asset prices this year. But in any event, our point is that the sharp drop in rates from this flight to quality from Europe could just as easily reverse upon the first whiff of stabilization in the Eurozone. We may already be seeing the first signs of this stabilization.

As for the economy in the US, many risks remain that will likely prevent a normal and robust bounce following a sharp recession.

We have covered these risks ad nauseum in previous market commentaries.

Personally, my biggest worry is the state of the housing market. However, by most accounts and metrics, the economic recovery in the US is solidly in place, even if growth will be well below expectations following a recession of such magnitude (a "U" rather than a "V").

Consider the following: 1) The private sector has created jobs for six straight months; 2) Capacity utilization has increased to 74.1 in the latest month from its low of about 68 last year; 3) the credit markets have improved dramatically, allowing larger corporations to access the capital markets again; 4) The stock market has rebounded some 60% from the lows of March 2009, creating substantial demand for goods and services from consumers (if only from wealthier consumers); 5) Corporate profits are rising sharply (mostly on increased productivity), and increased profitability should eventually stimulate investments in new employees and equipment.

As noted, this is not to say we do not have serious concerns about the economic recovery...we do. In fact, we are more on the cautious side as we believe US growth will be sub-par for many years under Mohamed El-Erian's "new normal" thesis.

However, this does not necessarily translate into a decade or more of Japanese-style deflation.

We believe the Fed has a much firmer appreciation of the risks than the Japanese ever did. We believe that the Federal Reserve is fully engaged and is more concerned about the threat of deflation than inflation.

Therefore, we would not rule out further quantitative easing, which effectively means printing money to offset the decline in velocity of money (banks not lending). In addition, we would expect the Fed to react to a continued slowdown by extending its commitment to maintain ultra-stimulative Fed Funds well into the future.

In our view, the fears of Tom Hoenig, the sole dissenter on the Board, are misplaced. However, we believe the rest of the Board "gets" it.

These students of the depression clearly know that the contraction in the money supply created by a financial crisis must be offset one way or another. If this is true, I guess the only worry would be political pressure as the electorate becomes more and more uncomfortable with government spending.

In our view, this is one reason why the independence of the Fed must be maintained.

Whichever way the winds of public opinion blow, Congress must get out of the way and let esteemed Mr. Bernanke do his job.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.