Thoughts on Inflation, Deflation and Interest Rates

We are now at the crest of a decades-long cycle of declining interest rates. Chairman Bernanke fears a Japanese scenario, where the strong Yen has been pushing the Nikkei lower and exacerbating Japan's deflationary woes with a 15-year high against the US dollar.

So the Federal Reserve has been keeping interest rates artificially low. By aggressively purchasing Treasuries, they keep the short end of the yield curve very low. And because treasury debt is mostly short term, the scarcity of long term bonds makes their yields fall also. In that way the Fed has taken over the entire yield curve.

As a result, we are experiencing a new paradigm, where both inflation and deflation are prevalent.

This dichotomy is vexing. On one hand, markets are flashing warning signals of global deflation. Yields worldwide are falling, on Japanese, US, German and UK debt. Real estate is declining. Large institutions are still deleveraging as a result of the global financial crisis and consumers are cutting back in response to unemployment.

But markets are also responding to the vast increase in money supply, and the gusher of cheap money making its way throughout the economy. There is fear that the only way out from the debt levels we have is to inflate the currency. Many commodities are soaring. Gold is hitting new highs. Cotton is trading at over $1 per pound, for only the third time in history (incidentally, one of the other two instances was the Civil War).

With the national debt nearing 100 % of GDP, a deficit of 10% of GDP and with Federal spending that consumes 25% of GDP, government expenditures clearly have to be curtailed. But to cut the budget to 20% of GDP, where it was in the roaring '90's, we would need to eliminate $700 billion in annual spending. Even then, we will still be running a sizable deficit.

Since interest rates on existing debt are not negotiable, the only two components of the budget that have the potential for that size of cutbacks are entitlements and defense. That leaves our political leaders with an impossible choice.

Cutting the entitlement programs -- Medicare, Medicaid, Social Security-- is political suicide, and reducing defense expenditures at a time of war also seems parlous.

And hence the inflation expectations.

It is little wonder then that markets are concerned with the Federal Reserve's policies. Chairman Bernanke has pledged to engage in quantitative easing and promised to ensure economic recovery. The Fed has considerable clout, but still markets doubt whether they have the tools to catalyze a recovery, and whether such promises can be kept. The scale of the quantitative easing program is unprecedented. The Fed does not have an easy exit strategy and withdrawing its efforts will throw the economy into turmoil. And there is no consensus among Fed Governors on how to do it, either. Seven members recently argued that the Fed should not take drastic steps just yet.

But what is important to understand is which of these circumstances are already priced in. All the concerns described above have been well publicized. Bond yields have not been this low since the 1950's, and I believe they are pricing in a pessimistic outlook of either another recession or an extended period of tepid growth.

Market prices always reflect a certain point of view, and sometimes they are right. George Soros coined the term Reflexivity to describe this phenomenon, in which market participants influence reality with their views at the same time that they are using market signals to form their opinions.

Currently, people are anticipating weak economic results. But if the economy moves in a different direction, prices will make an appropriate adjustment. Interest rates are not likely to decline much from here, but if the economy turns out less dire than the current outlook, and especially if inflation becomes more pronounced, rates could easily rise substantially, sending bond prices tumbling down.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.