I’ve been thinking about inflation, interest rates, and asset values lately, particularly with respect to how they effect business decisions that need to be made in the coming years. What follows is my attempt to work those out. Please leave your thoughts in the comments, as I make no claim to being right about what I’m about to post; it’s more like online note-taking.

Inflation is often described as “too much money chasing too few goods”. And this is technically correct. Inflation happens when the government introduces money into the system at a rate faster than new wealth is produced, leaving an oversupply of money, causing prices to be bid upwards.

I have long maintained that we are living in an inflationary period, that low interest rates were a major cause of the housing boom, and that the only reason why we didn’t see price appreciation in consumer goods and services was due to the influx of cheap goods from Asia and labor from India (via the Internet) and Mexico.

In fact, it was an incorrect definition of inflation that made the central bankers keep interest rates for so low for so long. Namely, that inflation is “price appreciation” and conversely, that deflation is “price depreciation”. This, of course, is nonsense. Price appreciation or depreciation is a symptom of inflation, but not a necessary indicator of it. In a normal economy, prices should gradually decrease for all manufactured products because technology improves over time. We see this most readily in the computer hardware industry, but it happens in slow motion across all industries. So when central bankers see small amounts of price depreciation (actually fueled by improved technology or new economies coming online) they often take measures to prevent deflation. But those measures involve increasing the money supply, which has to go somewhere, and often winds up creating speculative bubbles.

So far so good. arguably, then, when a bubble pops, you may have a brief period of actual deflation, in that people who had real wealth and invested it would have seen it lost, but on the other side, no small measure of people would have gained real wealth from riding the wave. On the other hand, some number of people would have increased their consumption, feeling that they were rich. Therefore, when the bubble pops, there would have been less wealth around relative to the amount of money representing it. On the other-other hand, in the aftermath of a bubble popping, many would-be investors will hold tight for fear of losing their money again, and this would represent some of the same symptoms as deflation, as it effectively is people hoarding their money.

Regardless, it’s hard to dismiss the combined orgy of government spending and borrowing, while the Fed maintains low interest rates and buys assets that they know to be worthless, all of which injects money into the economy, and not be worried about future inflation. The question is how will it play out and what to do about it?

Now here is where I get really confused. Traditionally, inflation should mean higher asset prices. Which is why holding precious metals or land would make for a good hedge. However, the price of assets, such as land, is inversely impacted by interest rates. And in inflationary times, interest rates will eventually rise to incorporate the rate of inflation. So if in normal times an asset (large enough to require financing) would drop in value when interest rates go up, and be bid up in value when interest rates go down, then how can land make for a good investment in rough economic times? Wouldn’t land actually decrease in price during real inflationary times because financing costs would drive prices down?

We are starting to see something like this in private equity as well, where EBITDA multiples for companies are dropping as the cost of capital rises. So is it that it makes sense to buy during inflationary times, only to refinance when times are better? If that’s the case, then the strategy makes sense to me.

So this would point to a strategy of not paying down existing debt (whether it be in a mortgage of whatnot) so long as the interest rates are reasonable, but investing heavily in hard assets (large enough to require financing to buy)? Then you refinance or even sell when interest rates lower again after the inflationary period comes to a close. But again, that assumes it ever does come to a close.

This would explain why people who bought their houses in the midst of double digit interest rates were able to cash out at multiples of what they paid, all the while they were able to refinance at a lower rate of interest when times were better, and perhaps use the savings to even buy a second house.

So am I missing anything here? This analysis would point toward not purchasing either a company or a house now while interest rates are relatively low, but instead waiting until rates go up, holding tight, and then selling or refinancing when normality returns some years down the road. Timing is everything in this environment. Does anyone have any sense of what one’s timing should be?

UPDATE: Upon rereading this, the prose is dense and confusing. I may try to rewrite the central question posed here in another blog post.

Tags: Asset Values, Economics, Inflation, LinkedIn, Money Supply

This entry was posted on Tuesday, July 7th, 2009 at 1:18 pm and is filed under News & Politics. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.