Inflation V Deflation – Which Door Do You Pick?
Another excellent post from Credit Writedowns. There are certainly strong opinions on both sides. I think the answer, as is the case with most economic debates, will lie somewhere in the middle.
Here are some of my thoughts on the matter:
- Under most circumstances government spending in excess of taxation results in inflationary pressures
-- However government bond issuance for soverign currency issuers [such as the US, Japan, Australia, etc.] does not 'fund' spending and is not related to fiscal operations. They have relevance in terms of facilitating monetary operations, they don't fund anything anymore. Taxes do not fund anything either. But Federal Government spending [which is how money is created] in excess of Federal taxes [which is how money is destroyed] is the only way to money to accumulate in the private sector (assuming a nation runs a trade deficit, which the US does)
-- The manifestation of price inflaton based on this activity is that the government spends extremely 'sloppily' and the funds to not distribute through the economy efficiently. When speculators get their hands on the funds (though investment banks usually) they bid up all sorts of things, including food / energy / speculative equities. In fact, by the time government created money gets to the consumer, it has passed through the banks / hedge funds / speculators / businesses , etc.
-- Quantitative Easing and any Central Bank Open Market Operations (OMO, of which QE is simply a variant) is not inflationary. It is an asset swap, no new net finanical assets are created.
- However, simply because there is excess government spending does not mean that the outcome is inflationary. This ignores the key component in the US economy... consumers. The US Consumer remains in a balance sheet recession. We started in 2000 at around $4 trillion in private sector debt, it peaked in 2007 around $13 trillion, and the last I saw it was still around $10 trillion.
-- Since this is case, I think there will still be weak overall demand for many years.
-- Which raises a further point to the inflation / deflation debate: Are consumers participating in the inflationary / growth themes? Or are they saving the excess government spending and paying down debt? Most of the evidence points to the latter.
- Assuming there is not wage growth commensurate with commodity price increases, this is a driver to the deflationary argument.
- This means that there is a hugely speculative (and not necessarily inflationary) component to the price increases that we are seeing in energy, food, and speculative issues. Is the primary driver inflation or speculation? Nobody knows the answer, but there is certainly a non-trivial speculative component.
- Given this situation, massive inflation (or hyperinflation) is unlikely to be a major problem in the foreseeable future. I think core inflation will tend to be mildly inflationary or even deflationary, with food and energy periodically spiking and crashing as producers cannot pass higher prices onto consumers and they cut production. There will be alternating periods of strong inflationary pressures from rising prices that will then reduce since economic growth is not the primary driver for the increases. This will serve to periodically 'squeeze' consumers.
This is obviously not a 'solid' prediction. But I think it is more of a vague outline of some of the forces at work in the debate.
Inflation V Deflation – Which Door Do You Pick?
Economy | Claus Vistesen | 28 February 2011 15:45
As the debate between the inflationistas and deflationistas appears about to rev up again, I thought that I would try to put pen to virtual paper and sketch out my thoughts on the matter.
The specific catalyst for looking into this is, naturally, in part the fact that oil looks set to do a round of catch-up with the rest of the frothy commodity space, but also this piece by the Pragmatic Capitalist citing David Rosenberg on the coming deflationary shock:
David Rosenberg makes some interesting comments in his morning note regarding the price action in US Treasuries. He cites the rally as a sign that the world is concerned about the deflationary shocks from rising oil prices:
“It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock.”
I think Rosey has this one spot on. The risk of rising oil is not a hyper inflationary spiral, but rather a deflationary spiral. Oil price increases are cost push inflation of the worst kind and for a country still mired in a balance sheet recession that means spending gets diverted which only gives the appearance of inflation in (highly visible) gas prices while creating deflationary trends in most (less visible) other assets (have a look at today’s Case Shiller housing report for instance).
Hang on for minute then. Do you mean to tell me that we have been running around worrying about QE2 leading to bubbles all over the place while the real danger is continuing and entrenched deflation? Well, yes this exactly what this means, but note the important distinction between the US (and the OECD) and emerging markets. Greed and Fear kicks off this week with the following point ;
(…) an oil-led commodity spike would clearly cause an intensification of the current inflation scare which has been hitting Asia of late with India the most vulnerable market. Still, as occurred in 2008, such a spike is likely to have the perverse effect of short circuiting the inflation scare in terms of duration. This is because sharply higher oil and food prices will hit current growing optimism on the US recovery. For ordinary Americans are not seeing the income growth to offset such prices increases.
And finally, just to make sure we get all sides of the argument we should never forget that stagflation is also looming as an increasingly likely outcome in parts of the global economy (hat tip: Global Macro Monitor).
(quote from the Economist)
Historically, the margins of retailers and manufacturers have been remarkably stable, says Carsten Stendevad of Citigroup’s corporate-advisory arm. If commodity prices continue to rise, they will eventually be passed on to consumers one way or another. After years of goods getting cheaper, consumers may have to start getting used to everyday higher prices.
This highlights a crucially important issue, namely the underlying trend of inflation in the global economy. It stands to reason that if the trend of global headline inflation is up due to structural capacity issues, an increased prevalence of adverse supply shocks and low interest rates, then bouts of headline price volatility may incrementally find its way into core prices. And in a deleveraging world facing the effects of a balance sheet recession, this is tantamount to stagflation.