Inflation or Deflation, Caution: TIP or TIPS fund

The following is my response to a buyer of the I-Shares TIP Fund. The buyer bought as protection against inflation, but he has been getting creamed by deflation. He sees the flood of reserves from the FOMC as the grounds for coming hyper inflation.


I understand your concern about the new fed reserves, because a good definition of inflation is too much money chasing too few goods, however, I think the world economy is in a state of deflation and it will be several years before we see high inflation rates again. Inflation is determined by both the supply and demand for goods and by the supply and demand for money.



1) Goods: The excess supply of goods is not going to be easily worked off. Oil is only one of many examples available; as a result of many prior years of exploratory drilling, production went from around 60 million barrels per day to 87 million barrels per day in just 6 years. In addition to this dramatic growth in actual production, by the end of the huge price run-up, the pace of effective drilling surged to record levels and producers around the world made massive commitments to long-term projects. Two examples tell the story.


While prices were soaring, Brazil executed very expensive exploration in deed water, through difficult salt layers. They hit back to back to back home runs. The estimates of the reserves discovered just keep going up. It appears that at least 150 Billion Barrels of oil will be recovered. After the discoveries, Brazil ordered 30 Billion Dollars worth of off-shore drilling ships to develop these finds. These ships will be not be allowed to sit idle, regardless of how low the price of oil goes. In the mean time, Shell has started developing a 485 Billion Barrel field in Canada. Canada holds substantially more oil than Saudi Arabia. In the past, the 485 Billion Barrels of gooey oil was not worth processing. Today it is, largely because of new technology. Shell has learned how to refine the oil by cooking it in place for about a year. New nuclear technology allows Shell to heat this goo for 70% less than it would have cost with natural gas. All 485 Billion Barrels will not be recovered with this technology but a couple of million barrels per day should be easy. Technologies still being developed (most likely the digestion of goo by tiny microbes that produce natural gas) will ultimately allow the use of most of this oil.)


Significant quantities of oil will begin to flow from these discoveries and from many others around the globe just when CAFE standards cut demand. CAFE standards go into effect in 2011 and they ratchet up for many more years. This round will produce the same results as those in the past. By the time the standards are fully implemented the amount of fuel being used will have gone down, even while available supplies have gone up. The marginal cost of the last barrel produced is likely to fall to around $35.


This story is about many commodities other than oil. The average car includes 40 pounds of copper and the average home 400 pounds. Before the 1990 recession, copper stockpiles reached the very low levels of about 500,000 tonnes. By the end of the 2001 recession stockpiles reached 11,500,000 tonnes. Three months ago we were back down to 500,000 tonnes.


Even though the demand cycle has been broken, producers will continue to run their very capital intensive mining operations. New mines will not be started but the existing ones will just keep on producing. Some years from now, stock piles will once again exceed 10 Million Tonnes. The price of copper has fallen from around $4.20 per pound in July to around $1.60 per pound today, a close parallel to the price of gasoline. Before this cycle hits bottom, copper is likely to be back under 50 cents per pound. Indeed, because nano technology is allowing the much cheaper production of graphite based materials, some that conduct electricity much more efficiently than copper, a large number of uses for copper will be eliminated before the next demand cycle heats up. In like manner, graphite is replacing millions of tonnes of aluminum and steel. So far, most of it is going into airplanes but as production capacity increases, it will replace much of the heavy metals used in autos.

Furthermore, China is hurting. More than 100,000 factories have been closed. The government is afraid of revolution. It is using massive dollar reserves to buy its own excess production of goods when those goods can be stored to meet future demand. Government factories have lowered wholesale prices of finished goods to zero profit margins. China was exporting disinflation of goods prices to the US until the shortages that developed the last couple of years. We are back at the other end of the cycle now. The Chinese are flooding the world with low cost goods. Inflation is too much money chasing too few goods but, because of productivity, innovation and excess supplies of labor in China and elsewhere, excess goods are flooding the world.


As you well know, hand held wireless phones and Netbook computers are rapidly replacing large desktop machines and millions of servers are being replaced by "cloud" data centers. This is another area where the demand for materials is falling rapidly. A related action is that as the price of liquid paper technology readers fall, thousands of newspapers and magazines are going out of business. Hundreds of thousands of video rental stores and book stores are being closed. Billions of trees are being saved. The cost of producing one more digital copy of a book is almost zero. The resources used to send a digital book by wire is a very tiny fraction of the resources needed to transport it from tree to store to home. This rapidly growing trend represents a massive increase in the supply of goods, every book in the library will soon be available by wire.


2) Money: Most of the money printed is a result of the multiplier that happens when banks lend the same dollars over again and again. The multiplier or velocity of money has fallen off a cliff. The Fed is enabling banks to lend by making reserves available but the public is no longer in the borrowing mood. The reason the FOMC is having to increase reserves so quickly is to prevent a dramatic drop in the money supply. When a consumer saves-up and pays cash to buy something, there is no printing of money involved.


Last year, the person who had a 7% car loan was a happy camper. Inflation was pushing 5% and his total compensation was going up even faster than inflation. Buying on credit, worked fine. His net income was rising even after the hit of 7% interest. Today, the 7% car loan has become a very expensive loan. The car has tanked in value; the price of a new one is certainly not going up by 5% annually. Instead of 5% inflation, lets say the guy is looking at 2% deflation. Instead of paying 2% real interest (7% -5% inflation) he is paying 9% real interest (7% plus 2% deflation). He also doubts if he will see a 5% raise. This guy does not understand what is going on with the economy but he is pretty sure he heard Hank Paulson yell fire. As a result, he and millions of others are eager to pay off loans. To the extent that loans are repaid, the money supply is shrinking. Instead of too much money chasing too few goods, we actually have too many goods chasing too little money. Too many houses are chasing too few customers.


Politicians and the media keep harping about how government debt is going to cause higher interest rates or higher inflation, but the fact is that government debt does not cause higher interest rates or inflation. It is the monetization of debt that ultimately causes inflation. Most of the funding done by the FOMC has been sterilized lending. The shifting of paper from the banks to the FOMC books has been offset by open market transactions. FOMC reserves have recently shot out the roof but so far there is little evidence of new excessive lending.


In boom times the multiplier causes about 5 times as much printing of money as is done by FOMC actions. Today, the velocity of money has slowed by even more than the FOMC has increased reserves. Once the recovery starts, it will be important for the FOMC to pull the reserves back-in, but that is easier to deal with than is deflation.


You are correct to be concerned about the possibility of future inflation, however, even if the democrats go wild, the timing is tricky. The Great Society programs of Johnson went into place from 1964 to 1968 or so. The hyper inflation did not occur until late in the 1970's. When Volcker and Reagan brought the hammer down, inflation responded promptly but it still took years to get to the low levels seen in the 2000's. It remains to be seen how much printing of money the congress will allow Obama to do. The blue dogs will have a lot to say. In any event, high inflation rates should be years away.


Finally, even if you want the protection of TIPS against inflation, you should consider buying the individual bonds. By buying at par value, you can eliminate the downside risk of the fund. The fund holds bonds that have appreciated above par to as much as 1.3 times par. By buying above par value, you have accepted the risk that deflation will cost you 30% of your principle.


To add insult to injury, the fund has a .2% fee. .2% is substantially lower than the fees and hidden fees in managed mutual funds but it is a significant amount on a low yield fund. I have never purchased a TIPS, but I believe the issuing costs are paid by the government. Your cost to acquire and to hold the bonds in your account should be zero.