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Episode 27

Economic crisis: Inflation shock or deflation bust?

Published on: May 5, 2020 • Duration: 21 minutes

This week we look at the inflationary and deflationary pressures that are impacting global economies. Can money printing manufacture inflation, or is this a true deflationary shock? Inventories will build and supply chains will be disrupted, creating dislocations in both directions, but the underlying economic fragility that existed pre-crisis may force consumers and corporates to de-lever their balance sheets.

  • [00:00:05] The current crisis has led to demand destruction of historic proportions, and in order to combat that economic fallout, policymakers from the US to Japan are combining a monetary and fiscal response of unprecedented size and speed. Will this lead to a sudden surge in inflation? Or is deflation already baked in the cake? That's The Big Conversation. 

    [00:00:30] There is obviously going to be a big inflation / deflation debate coming over the next few weeks and months. And with the stock of M2, which we'll come to later, this is money supply, exploding higher there is a view that inflation, which is always a monetary phenomenon, or at least that's what some people think, though it really isn't, that the fears about inflation, they're beginning to rise once more. And when we think about inflation, we tend to think about the number of goods that, for instance, a single unit of currency can buy today, versus what it might have bought in the past or even can buy in the future. And over the last decade, economists are tending to actually be more concerned with deflation rather than inflation. But there's a whole lexicon of terms that are frequently used now. We have inflation. We have deflation. We have disinflation. We have stagflation. And we also worry about hyper-inflation. So when we talk about inflation, are we concerned with economic growth and economic inflation? Or is it wage inflation? Or is it goods inflation or asset price inflation, such as equities going up, which has been the dominant inflation of the last decade's era of quantitative easing? And of course, individual experience has also played its part. For instance, rent, Medicare, private education have tended to move in one direction higher. Whilst consumer items have benefited from the forces of globalization and have tended to move lower. Currency has also been devalued and that's so that (the one year difference) for instance, dollars or pounds, may buy fewer items today, but this has actually been offset by higher levels of compensation. So even though it feels like real wages have stagnated for the average employee, most people have been roughly able to buy the same number of goods because wages have gone up. So inflation and deflation comes in many shapes and forms and not all forms of inflation are equal. But many people remain on edge that the outcome of the current bout of money printing could lead to a form of chronic inflation. So what should we expect? Well, we'll look at the Consumer Price Index CPI in the US going back four or five decades. What we can see is that CPI in the 1970s was extremely high. This was the period of inflation and stagflation, so low growth and high inflation. And it came to an end really when the then Federal Reserve chairman, Paul Volcker, came in and he raised interest rates to an extremely high level and that helped push those CPI levels back down again. This was in the early 1980s where we also saw some recessions. But the CPI dropped precipitously to around about two and a half percent back in that early 80s period and in reality actually stayed in a sort of zero to five percent range ever since. And I think what we saw in the 1970s really was a combination of impacts. There was the money printing going on, we got to the end of the gold standard and the US was able to print money because of the petrol dollar petro dollars system, the euro dollar system, which was really still in its infancy back then. But more importantly, I think we had a couple of bottlenecks. One of them is that we had postwar the system that had been put in place was one very much with a welfare state. A lot of government and quite inefficient, which created bottlenecks. In the US. you saw the baby boomer generation really starting to go into their spending mode. So that was a demand surge that came through. Also, globally, the rate of change of population growth on many estimates peaked in the 1970s. Now, this is the rate of change, not the absolute numbers coming onto the planet. But the way to think about it, is if you thought 100 million people were coming on the planet, 200 million people arrived, putting upward pressure on demand. And then within all of this, you had the OPEC agreements which reduced the supply of oil and pushed oil prices higher, so you got a commodity squeeze as well. All these things came to a head in the late 1970s with kind of these recurring recessions and inflation, and that's where Paul Volcker came along. What's surprising in some ways is how long it took yields, particularly longer dated yields, which have extra sensitivities to future inflation expectations. Those yields did not drop anywhere near as rapidly as inflation. So when CPI came to two and a half percent, 10 year yields ground lower over a long period of time. And a lot of this was to do with inflation expectations. Some people would call this term premium, which is the amount of additional yield you need to put in or factor into a longer dated bond yield in order to take account of the uncertainty of inflation. Well, what's happened over the last few years particularly is that those inflation expectations have collapsed. So the 10-year term premium is now in negative territory. So we saw this inflation, but inflation has been relatively well behaved over that period, at least at the headline level. Yields have come in and this has really been driving that period post the 1970s and through the 1980s. And in many ways what many people are worried about when they see this gargantuan expansion in the US Federal Reserve's balance sheet. Now at the beastly level of 6.66 trillion and expected to probably rise towards 9 or 10 trillion by the end of the year, is that there's this spectre of the previous periods of excessive money printing, such as the Weimar Republic of the 1920s, where there's a famous book called 'When Money Dies'. And more recently, the experience of Venezuela, where inflation reached 500,000 percent, completely debilitating, and these sorts of inflation destroy economies. So people are very worried about that. But the US has been printing for a long time and it's not caused excessive inflation yet. But that's because the US currency is the global reserve currency. But nonetheless, particularly over the last 10 years, we've seen money printing. But more importantly, the velocity of money which will come on to later, has declined, and this has some ways offset the money printing. So in reality, what we've seen is the inflation has been asset price inflation. But economic inflation, i.e. growth has been absent. And in fact, what it's done is this cheap capital has encouraged really weak companies and inefficient companies to borrow capital, it's kept them on life support. And this has resulted in what many people now call zombie companies. But we've seen zombie economies and zombie households as well. And that is a force for lower future growth. So then that comes on to well, what about today? What are the particular intrigues and interests of this current environment and the setup that we're seeing in terms of a new bout of money printing and also the fiscal authorities coming in with additional support for the economy? Well, when we look at today's global economy, there can be no doubt that there has been probably an unprecedented level of demand destruction over a very, very short period of time. And that sort of demand, destruction is recessionary. And recessions themselves are I don't want to say deflationary, but they are certainly disinflationary, or lead to lower inflation. And we can see this even during the periods where there was stagflation or inflation of the 1970s. During or immediately after the major recessions, we always saw U.S. CPI dropping much lower. So it was still in positive territory but inflation or the trend of inflation was towards lower levels of inflation in the immediate aftermath of each of those recessions. So what about today? And already we've seen a stunning drop in GDP and the move that we've seen in the US is only for Q1, and most of the impact of the Coronavirus outbreak is expected to be felt in Q2 and then throughout the rest of the year. What we can see is that as well as GDP falling off a cliff, personal consumption in particular for March alone, if we take that one month in isolation, this is a quite incredible drop when we look at the last 40 years or so of the history of this data point. So in the US there has been a significant drop in personal expenditures. And in some ways it's even worse outside of the US when we look at French household consumption. This has seen an even more dramatic drop to minus 17 percent. So these figures are being repeated globally and these figures are being repeated at the household level, at the consumption level, which particularly for developed economies is the majority part of their overall spending and their overall economic growth. And so whilst that form of demand destruction is very clearly deflationary, as we see this demand getting destroyed. There's also other problems in terms of reopening economies which are part of a global supply chain, so these global linkages. We're not just seeing demand destruction, but we are actually seeing the reopening of some economies, which means that supply could be coming on line again. And what we're looking at here is in places like China where again, regardless of whether you believe the data or not, China has brought its manufacturing back on line. And in many instances where you have consumer businesses or you have production facilities, which can easily be sort of put into mothball and taken out again. So I'm not thinking of mines and kind of extraction industries, which once you mothball those, it takes a long time to bring them back on line. But for production lines, consumer good lines, those can be brought back on line quite quickly. And it might be easier to bring businesses back on line than it is to stimulate true aggregate consumer demand. So what you are you having from China, you can see this in some proxy data, some of the alt-data, is that the manufacturing, the industrial manufacturing is getting back to around about 80 percent of where it was before. But when you look at international travel, international air travel, it's only 25 percent of what was going on before. This is not apples with apples, but let's pretend that the international travel is a proxy for the state of international demand. Well, if you're bringing your manufacturing capabilities back up to 80 percent because you're being stimulated by government loans, but the aggregate demand of the consumers still remains in lockdown, then again, you're going to get another inventory bill, which is obviously when you get an inventory bill, look what happened to oil, that could again happen. And also these companies which are building these inventories, we'll see margin destruction there, having to pay their workers they're having to pay for factories, but they're not getting any cash flow. They're not getting any revenue because demand remains very, very weak. So those two factors, the absolute destruction of demand and then the restarting of some economies without the demand coming back, those are forces for deflation. At the same time, we are seeing potential for inflation from some of the supply chain bottlenecks that could appear and we can already see some of these happening. So, for instance, in the US, the price of goods from farms, i'm thinking live cattle here, has been falling. But at the same time, because the processing plants have been mothballed only for a few weeks or even a few days, but because processing facilities have been taken down, it means that the actual availability, the process goods has been falling. Demand is still relatively strong for essentials such as food, so that's putting some price pressure to the upside on some of those processed farm goods. But at the same time, the prices that farmers are getting have been collapsing. And this is what we're seeing in some ways with those corn prices as well. You can see and you've probably all heard of some areas of price gouging for demand for certain items where the supply chains are down, the items are still in high demand because of the situation that we're in, and prices have gone through the roof. There is very clearly some inflationary bottlenecks there, and as I mentioned before with mining, if you're taking down either the extraction or the processing facilities in heavy industries such as mining, these are facilities which can take a long time to restart. They're not just put into mothballs for, you know, a couple of weeks they can be often taken out for a couple of months. And so when the demand comes back, is stimulated in the future, it will take a long time for these sources of supply to come back on line, which is one of the worries that people have that you might get some inflationary bottlenecks. And so what's going to happen to aggregate demand from consumers? And for this, we can go back to the M2 charts, the money supply charts, and particularly the velocity of money. So firstly, what is M2? And M2 is is basically a collection of cash, checking deposits, saving deposits, money markets, mutual funds, all sort of pulled together. And M2 is going up very rapidly at the moment. And the way we look at the velocity of money supply, so the velocity of M2, is we look at the gross domestic product or gross national product and we divide it by that money supply. Velocity of money will be falling if you're seeing either a decrease in GDP or GNP and an increase in money supply. Well right now we're going to get both. Now, in fact, the velocity of money was falling throughout the period of QE for the same reasons, flat GDP, but money supply going up. So when we were seeing money supply rising, velocity of money was falling. And during this period, we had low growth and declining inflation expectations. Today is very much the same. And so what we're looking at inflation, we have to look at CPI and compare it to the change in velocity of money. So if you look at the year on year change in the velocity of money versus the year on year change of CPI, we can see there's a relationship. And if the velocity of money M2 starts to decline rapidly, we should expect CPI to fall. Now, at the moment, we're still waiting for Q2 figures, but if we expect money supply to increase rapidly, which we do, if expect GDP or GNP to fall further, which we do, then we should be expecting inflation to fall further from here. In fact, CPI probably should be going negative when we look at this. And that's going to have a profound effect on human behavior and how consumers are going to act going forward. I think here we can look back over the last 10 years and the period of QE, and what's been remarkable post the great financial crisis is that consumers continued to spend and they recovered very quickly from the housing and mortgage crisis of the mid 2000s, largely because those interest rates fell dramatically and then QE also came in and supported growth, although in some ways maybe it supported a very low level of growth. And I think what matters here is whether people will change from pre crisis, this is pre-Covid crisis. When you had low interest rates the feeling was why would you want to save if you're going to put money in the bank and get nothing for it? There's no point in putting money in the bank. And that was actively what central banks wanted people to do. They wanted people to spend, and people spent and they levered up. What they should have done, what we all should have done is actually saved more and more capital. Because if you're going to get no future income, because interest rates, yields, dividends, et cetera, are very, very low, you need a larger pot of capital to then draw that down in the future, particularly when you think of pensions. But instead, everybody levered up and effectively was living in a lot of places, particular in North America and the U.K. from paycheck to paycheck. This meant that the backdrop over the last 10 years was and is incredibly fragile. It means that balance sheets were very, very weak. This was at the household level, the corporate level and at many government level globally. What has happened this time around is we have seen a massive hit to the consumer part of the economy. It's the leisure facilities, so it's transport leisure, it's holiday making, it's eating out. All of this part of the economy is in lockdown. And even when it comes out of lockdown, it's unlikely that this is going to come back very quickly. What this means is we're going from what is a liquidity problem, where it's just a short term issue with regard to can I pay myself or can I keep myself going for another week, to a solvency issue, which is I'm never going to be able to pay back my debts, and I'm never going to be able to fix my balance sheet. My balance sheet is now impaired because my income has disappeared. If I was going from paycheck to paycheck and I've lost one paycheck, suddenly rent goes in arrears, mortgage payments go in arrears, credit card payments go in arrears. Credit scores will start to decline. And this is likely to change behaviors quite dramatically. So can we see this in any of the behaviors? And I think the key one here is when we think of the dollar, we call it stimulus, but it's not really stimulus, but the accommodation that is coming. How much is one dollar of stimulus actually finding itself as one dollar into the economy? And it looks like it's not. It looks like there's a very small percentage being spent, and a significant amount is being saved and some is going to pay off debt. We can actually see the personal savings ratio in the US has now gone to the highest level since 1983. It's currently at thirteen point one percent, and we have seen these spikes before so it maybe that it dissipates quite quickly, but the trend has been to a higher and higher savings rate. If household balance sheets are now impaired, it looks as though households are going to have to start thinking about paying down debts, paying off credit cards, worrying about student loans rather than thinking about consumption. This is going to have a significant social impact because it's going to become a solvency issue rather than a liquidity issue, because wages and future cash flows across the whole economy, starting at the individual, the corporate and ultimately the government, these are all going to decline. So this looks like it's going to be profoundly disinflationary or deflationary in the first instance, before the supercharged level of central bank and government fiscal and monetary stimulus can start to exert upward influence on demand and then react with those potential bottlenecks of supply that could create a high level inflation down the road. But that's probably for two or three years from now. And obviously there are concerns that money printing will eventually create inflation. But if all the main geographic regions are printing, then their currencies are going to go nowhere, and you need the currency to move to create the inflation, at least of incoming goods. The Fed's probably got a bit more room, it's got the reserve currency and as a percentage of GDP, it's not printed that much yet. But if the dollar devalues, and the euro devalues and the yen devalues, and the pound devalues, then no one devalues. The Fed is likely to need to do much more. We talked about 'they're going to need a bigger bailout' in a previous episode. But these bailouts really are hitting the void. They're filling the void. These are not a stimulus yet. So far, we've seen maybe in total six trillion in terms of both fiscal and monetary that's been announced in the US. But this is probably less than a quarter of the total destruction of wealth via asset price declines. And this is probably why if we're looking at the market and thinking about the best way to express the ongoing demand destruction, then the release valve is going to be in emerging market FX. It's going to be in those economies which can't print, which kind of perversely you have thought those countries which print will be those countries which have the weakest currencies. But for the Fed and for the US, printing will actually probably encourage capital in as we've discussed before. But if you only can only cut interest rates, if you can't print to support your currency, if demand for your both manufactured and commodity goods either or in emerging markets continues to decline as we see balance sheet retrenchment, then it's going to be those emerging market currencies which will be the best expression of weaker global growth and weaker global economies, rather than necessarily some of the financial assets of, let's say, the US, where money printing could once again find itself into financial price inflation. But what we really want here is wage inflation, real wage inflation and real growth, real economic growth. And given the dynamics of velocity of money, given the balance sheet dynamics of households, given the balance sheet dynamics of corporates and also many emerging market governments, it seems very, very unlikely that we're going to see the stimulus becoming an inflationary force in the short term. Much more likely is that this rebalancing is going to continue and force a disinflationary or deflationary impact on global economies over the coming months before the fiscal can really take hold in the coming years. 

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