Since 2008 quantitative easing and other “non-traditional” monetary policies have often been a subject of articles in the financial press and Altus Insight distributions. There were arguments that these policies were causing the economy to move into deflation and loud and voracious arguments that inflation, big inflation, was on the horizon. I could, and still can, make the argument for either scenario. At various times I could be found holding various positions along the deflation/inflation continuum but always trying to structure investments with both possibilities in mind. As we continue to muddle along a rather unimpressive economic recovery it is clear we will not have a clear answer for the foreseeable future, but recent economic results and an article released by a top economic advisor to Vladimir Putin makes this month as good a time as any to revisit the topic.

The third (and final) revision of the first quarter gross domestic product was released this past week by the Commerce Department and to the surprise of nearly everyone with an opinion, the economy contracted at an annualized 2.9% rate. Economic contraction by definition is deflationary. In Europe the European Central Bank lowered the rate it pays on bank deposits BELOW zero, meaning banks had to pay the central bank to hold their deposits. This is because economic conditions in Europe are setting of deflation alarm bells.

Meanwhile, the Federal Reserve governors expressed surprise at the May CPI (Consumer Price Index) numbers which suddenly showed a year over year inflation rate of 2% and month over month increase of .4%, twice that of the survey consensus. For those keeping score at home a monthly inflation rate of .4% equates to just under 5% annually, a rate which has only been reached once (1990) in the past 32 years. As investors, we had better hope we don’t own many fixed income positions today if inflation is 5% over the next twelve months. For now, or at least through the first 5 months of the year the core CPI has increased at a rate of 2.3%, quite a bit above the rate consistently touted by the Fed as the target inflation rate to which they were trying to drag the economy, the whole time with the implicit promise that interest rates would rise once inflation hit 2%. Just so you are in the know, the Fed did not raise rates and is saying rates will not be raised until sometime in early 2015 at the earliest.

The following chart was printed in Grant William’s weekly “Things That Make You Go Hmmm…” distribution. The following information encompasses two major recessions and still…yep, inflation over 2% per year, with many items far above the magic barrier.

So what does it mean, inflation…deflation?  Let’s head to Russia.

I find it interesting and useful to read articles printed in periodicals written in other parts of the world in economies and societies with different viewpoints than what we consider to be common knowledge, or at least the that the US press considers to be common knowledge (Der Spiegel is one of my favorites since Germany is an such an economic powerhouse). An economic advisor to Putin recently published an article that outlined a plan for undermining US economic interests to force the US from inserting influence on the Ukrainian situation. While it is interesting from a curiosity standpoint to see language like “only way of making the US give up its plans on starting a new cold war” or “Washington is trying to provoke a Russian military intervention”, the true interest of the article as relates to inflation/deflation lies in the economic points made in the article. The author gives the US more strategic credit than I normally would under the following abbreviated hypotheses:

1. The US is trying to get Russia involved for its own economic benefit.
2. Russian involvement would provide excuse for additional sanctions, including writing off the US Treasury bills currently owned by Russia (benefit #1),
3. The sanctions would stifle Russian economic activity reducing their ability to pay European banks on the debt owed to them,
4. The losses to the European banks would be higher than 1 trillion euros, severely hurting the European economy and strengthening the US’s case as the sole safe haven currency in the world,
5. Sanctions would stifle Russian natural gas supply to Europe requiring them to turn to the US for supply (US liquefaction facilities are close to coming on line), strengthening the US economy (benefit #2),
6. An increase in cold war tendencies would increase the US’s political influence in Europe (benefit #3),

The accuracy of the above claims aren’t nearly as important as the author’s suggestions to battle the above items (again, whether real or imagined is unimportant). The author believes the US printing press is the strength of the US machine and that creating a broad based anti-Dollar alliance is the key to resistance with strong arguments why even Europe and European businesses are better off moving away from the Dollar. Basically, the thought is that the war for Ukraine may become the war of Europe’s independence from the Dollar.

This is where the Russian conspiracy theory ties into the subject of the month’s article. Back in December of 2010, Altus wrote of the possible magnification of inflation if the Dollar lost its place as the world’s reserve currency.  In 2010 it was estimated that between 40 – 60% of physical US Dollars circulate outside the US. Additionally, many countries buy US treasury debt that can then be used in trade since it is Dollar denominated. The Federal Reserve’s figurative printing presses have been consistently humming since 2008 and yet inflation has been muted thus far, befuddling many who predicted the increase in liquidity would lead rapidly down the path of inflation (an outcome almost certainly preferred by the Fed itself). In addition to the plummeting velocity of money one reason that inflation hasn’t resulted as quickly as many thought or hoped is so much of the liquidity has been captured outside the US, either to buy foreign assets or in use as a facility of trade.

While not perfect, the garden hose can be used as a workable analogy to explain what this might mean to the US (read the December 31^st Altus Insight for more detail). For water to come out one side of the hose not only does water have to go in the other side but there is also a requirement for a consistent amount of water within the hose. This “in hose water” allows the new water entering the hose to push water out the other side of the hose. The “in hose water” is always changing but there is ALWAYS an amount of “in hose water”. In this analogy this “in hose water” is the currency being used to clear trades between foreign trading partners. That currency (in aggregate amount) never enters our economy, and so long as that foreign trade continues and continues to use the Dollar as the medium of exchange, then it never will. Going back to the garden hose analogy, this foreign trade is a very, very long hose, remember, an estimated 40 – 60% of USDs are outside the US. What happens if the hose gets shorter, or more drastically an entirely different hose is used? That “in hose water” becomes useless.  In practice the US Dollars being used for trade would become unnecessary and only have one remaining use, which would be to buy US goods or services. This could create a short term boost to the economy through increased demand of US goods, but more importantly the US Dollars in circulation within the US economy would double. Since the goods and services traded within that same US economy wouldn’t correspondingly double (and everything else being equal) this would lead to a reduction in value of each US Dollar. This is otherwise known as inflation.

I am not saying I am buying the Russian economist’s view belief that war in Ukraine is all part of a US government master plan to strengthen its economic position (I just don’t think we are that smart). Nor do I even necessarily believe that Russia believes that war in Ukraine is a US master plan, but that is hardly important. What is important is that the story is plausible enough to make affected parties consider it, see the truth in the possibility, and maybe take steps to insure that it doesn’t affect them.

For the past couple years China has been quite outspoken about moving away from the US Dollar as the reserve company and has already reached direct currency trading agreements with several of its large trading partners such Brazil, Russia, and South Africa.

It is likely the US Dollar will lose its status over time. Things change. We must expect nothing different. Most likely our economy can absorb a slow reduction in use over time but a sudden stop to use of the “hose” could have a drastic impact to our economy, our investments, and our lives. Most likely it will take a geopolitical event for this to occur, but as investors it is unlikely we have the ability to accurately predict such events. Even after the Arch Duke of Austria was murdered one hundred years ago this month very few people thought it was an earth shattering event for the world as a whole. Instead it led to one of the largest and most brutal wars in the history of the world. And one month to the day after his assassination the financial markets figuratively blew up leading the New York Stock Exchange being closed for business for four months. During this time no one that owned shares in the companies traded on the exchange could trade out of their positions unless they found a real counter party with which to do business, and supposing those counter parties could be found, you can be assured they weren’t buying at the share prices in place when the market closed.

Inflation? Deflation? More of the same? Lots of smart people have conflicting views. While I may have my own opinions they certainly are not strong enough to be considered a conviction on which I, or Altus, would base an investment strategy. Instead we continue to strive to identify and execute on investments that can be expected to perform decently well regardless of what occurs. This doesn’t mean it is the only way to play the game, nor would we be so brazen as to claim it is the best way to play the game, but we do feel strongly it is the best way we can play the game and the best way we continue to bring value to our investor partners.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.