The inflation deflation debate
Published on: August 27, 2020 • Duration: 21 minutes
This week we look at the spike in US CPI data is a sign of higher inflation to come, or whether deflation is baked in the cake. Fiscal and monetary policy are expected to drive inflation higher, yet these policies may continue to exacerbate the deflationary effects. In the Chatter, we review the recent surge in US and UK housing data, even whilst mortgage delinquencies rise. In the Whisper, we look at the drop off in market volume that is extreme even for the vacation period, increasing the risk of equity air pockets.
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[00:00:05] Over the last few weeks, inflation data has started to pick up, reigniting the whole inflation debate that we last tackled on May the 4th. For investors, savers and policymakers, inflation remains one of the most pressing considerations, not only for the next few months, but also for the next few years. That's The Big Conversation.
[00:00:28] The consensus view has been building that the corona crisis and the ensuing economic lockdowns would create firstly a bit of deflation, but with some inflationary bottlenecks, and then more widespread inflation further down the road has the combination of fiscal policy, which has government spending, and monetary policy, that's the lowering of interest rates and the expansion of central bank balance sheets, would structurally change the outlook in favor of inflation. When we were conducting interviews for our five part What Now documentary series, a clear majority of the respondents thought that the longer term effects of the crisis would be for higher inflation. And many of the inflationary camp will feel vindicated after the recent surge in CPI data in the US, where the month on month change was nought point six percent, well ahead of the expected increase of nought point three percent. The higher than expected inflation data was repeated in the UK, where the retail price index rose nought point five per cent against an expected rise of nought point one percent. Now the inflation debate is, of course, a minefield. Are we talking about inflation, reflation, stagflation, hyper inflation, deflation or disinflation? And time-frame clearly matters. Potentially, we could have a deflationary environment that then leads to a period of sustained inflation and vice versa. Also, inflation and deflation can mean very different things to different people at the same time. Now, we've covered most of these arguments in that May episode of the Big Conversation, but it's certainly worth reviewing the outlook for inflation and deflation again here, because the arguments are starting to hot up again on both sides of the fence. Perhaps the first question is whether the current spike in CPI is the start of that big inflation that many see, or whether it merely has its roots in some of the recent market dislocations that have created pent up demand or short term supply bottlenecks. Firstly, let's look at the fiscal side of the equation. Government debt to GDP ratios has started to skyrocket again, as can be seen here in the UK. It is this increase in fiscal expenditure that for many observers will push prices higher. But at this stage, have the fiscal authorities created a level of demand that exceeds the level of demand that existed prior to the pandemic? I think the answer to that question is clearly no. Fiscal expenditure has gone toward wage support, but not, for instance, infrastructure spending. In fact, much of the current talk is about extending the furlough schemes, and that can only mean that the recovery is incomplete. Without government intervention, jobs would have evaporated and they might still do so. Economies have not yet recovered to the former levels of growth. Fact the declines were so steep that what now looks optically like a full recovery still leaves many measures of demand trailing well below the levels experienced during prior recessions. So the fiscal response has been one of support, not stimulus. The recovery's still reliant on government expenditure to maintain demand that currently falls well short of pre-covid levels. But the rebound in US CPI is a little surprising because during previous US recessions, year on year, CPI fell precipitously. This time, however, the decline has been relatively subdued. Both the weaker US dollar and the short recession may have helped, but this should be showing up in future, not present datasets. And besides, the worst of the economic fallout may still be ahead of us. The recent spike in inflation data is therefore more likely to be the result of a number of short term factors. Firstly, on a month on month basis, we've seen a strong rebound in many commodities that would have fed through to a rebound in many input prices. Secondly, we did see some supply chain disruptions that caused both inflationary bottlenecks in outputs whilst collapsing demand caused input prices to fall. You may recall that US cattle prices fell because abattoirs were forced to close, leading to a glut of live cattle. And as you can see here, a surge in processed meat prices because of a lack of finished product. Many supply bottlenecks remain. Very early on in this series, I outlined the risk of short term spikes in inflation if supply chains were disrupted, whilst at the same time demand was stimulated by fiscal expenditure. However, this is not permanent demand, but specific demand bottlenecks, where furloughed workers were benefiting from paychecks while some consumer staple products were being pressured by supply constraints. An example of this is the surge in US lumber prices on the back of demand for renovations and a building boom catering for people looking to leave urban centers. The change in demand only needs to be at the margin, but the speed with which many people have left urban centers, even if on a temporary basis, has caused an impressive price squeeze. Demand may also have received a boost from revenge spending as people feel a sense of liberation as they come out of lockdown. That potential could be seen in the US personal consumption savings and income data. Personal consumption initially collapsed as households went into lockdown before rebounding from a very low level. But personal income briefly skyrocketed despite the vicious recession as furlough schemes kicked in. Saving rates also went to record levels. Savings have now dropped back, but are nowhere near their long term trend. This represents potential pent up demand. Most of the US and European markets came out of lockdown at around the same time, and their inflation data spiked at around the same time. Therefore base effects on commodity prices and really spending out of lockdown are the likely causes of the recent CPI spikes. But they will be temporary effects. In other regions such as China we have seen supply being stimulated whilst demand has remained sluggish. Here the focus has been on reopening the productive capacity of the economy rather than on furloughing workers for an extended period. And as Chinese households came out of lockdown, we did see a pickup in demand. But footfall data showed that initial exuberance soon faded, suggesting that consumers are reluctant to fully reimburse their previous patterns of consumption. Perhaps one of the most powerful arguments supporting an expectation of higher inflation has been the efforts of central banks, who have expanded their balance sheets at a record pace. But this merely mirrors the record decline in demand. It has not offset the losses. If yet more balance sheet expansion is required then it again suggests that the economy is still struggling with growth. It's easy to forget that after 10 years of QE, this remains an abnormal policy response that has become legitimized through time. Central banks, were not doing QE because growth was motoring along, they were doing it because growth was weak, particularly the prospects of future growth. That is not changed, if anything, it has got much worse under Covid. But when we see a rapid expansion of central bank balance sheets, we assume that inflation must be coming. But central banks don't spend. They rely on other actors to do the spending. What they do provide, for instance, is collateral for commercial banks. The commercial banks will then apply leverage to this collateral. But this entirely depends on the banks wanting to lend, and the corporates and households wanting to borrow. It is not a function of the size of the Fed's balance sheet. If the economy was doing well and there was any demand, then one trillion in new reserves could be leveraged up into something like 10 trillion of lending. In fact, during the good times, banks don't need encouragement to lend, and businesses don't need encouragement to borrow. But if there's no desire to lend or borrow, then five trillion of new reserves could lead to negligible increases in lending and borrowing. QE on a strong economy could be inflationary, but this is not a strong or a tight economy. And anyway, this QE will probably find its way into alternatives to economic growth, such as asset prices as we are seeing in the equity market today. And in this current environment, do you think banks are willing to lend? Are businesses and households willing to borrow? The surge in corporate borrowing that we have seen this year has been emergency funding to replenish reserves and offset lost cash flow, but that's not growth. So balance sheet expansion does not equal growth. But as discussed before, the fiscal side could step into the breach. But even here so far, the fiscal side has provided recovery funds, not growth funds. If anything, balance sheet expansion and fiscal support has created extremes in asset prices. Bubbles are not inflationary, apart from the inherent asset price itself. But the higher a bubble goes, the more it diverts capital away from other productive opportunities. And when bubble's burst, that's also deflationary. So keep the bubble alive and you reduce growth and inflation opportunities elsewhere. Let the bubble collapse and you have outright deflation again. Next, if you look at debt, have debts increased or decreased? Clearly they've increased at almost every level. High levels of debt are deflationary because it will require even bigger fiscal and monetary responses to offset them. Recently debt repayments have been put on hold. But as the requirement to pay off debts returns, cash hoarding will again increase and the velocity of money will fall further. Much of the outlook for inflation depends on whether you think the crisis is a demand shock or supply shock. Did consumers involuntarily go into lockdown? While in many cases the answer to that is yes, they were forced to do so by governments, there is also a lot of evidence to suggest that the decline in demand started to take shape well before lockdowns were imposed. Since lockdowns have been eased, consumers remain cautious, having now experienced what it's like to not have a rainy day fund. And remember, the economy was not in a state of great health prior to the impact of Covid. The velocity of money has been falling for years. So what about over the medium to longer term? One of the arguments for future inflation is declining globalization, which previously had helped push the prices of many consumer goods lower over the long term. A reversal in globalization is currently expected to lead to an on-shoring of jobs and a higher cost of labor. But the outperformance in global tech stocks reflects the trend of acceleration and concentration in which technology displaces labor. Rather than the integration model, which would see man and machine work in unison. Fewer jobs means lower wages and a need for yet more government support. If all jobs could be automated, and obviously that's not a real world scenario, then there would be no wages. Now that's not going to be the case, but at the margin, jobs will be replaced. So the governments will have to keep their fiscal impulse running just to standstill. Again, this is not long term inflationary. On shoring of industry with technology, replacing labor means that labor will take a smaller, not larger share of capital. However, the good news is that globalization took 30 years to reach a peak. And it's not going to collapse back in the next couple of years. But this is a multi decade reversal. And another question is, who is going to pay for the current expenditure? It would require a never ending QE tied to never ending fiscal expenditure in order to offset the deficits that are building at the household, corporate and government level. Infinite MMT may eventually lead to inflation. But are policymakers currently trying to create inflation or stop deflation? I think it's the latter. Meanwhile, governments will also be searching for new sources of revenue. Whilst austerity on public services such as health will be avoided at all costs, wealth inequality means that individual and corporate winners over the last few months could face wealth and windfall taxes, which could offset some of the potential growth impulse from combined fiscal and monetary policy. Even if the authorities were able to generate inflation, it would need to be reflation to be effective. And reflation is where the economy grows as well as the price of goods and services. Wages need to increase, preferably faster than the cost of goods and services so that real wages rise, although in reality only nominal wages need to rise to reduce the debt burden. In that scenario, levels of debt which remain static will start to decline relative to wages, making them easier to pay off over time. But is reflation likely if jobs are being lost through automation? It's more likely that if we get inflation, it will be again without growth. And that's called stagflation, not reflation. We're probably only one inflationary spike away from a true deflationary bust. Although central banks will try to hold down yields to a yield curve control, but this will continue the last decade's tradition of capital misallocation and the survival of zombie companies at the expense of growth. Given the risk of stagflation, how hot will central banks want to run their economic policy? The Fed may have changed its criteria to allow more flexibility on inflation targets, but debilitating inflation could destroy median real wages, leading to yet more populist backlashes. Germany is certainly not ready for rampant inflation. Very few aging societies will have a high tolerance level for inflation that destroys savings. And this is a far cry from the 1970s when savings were lower and populations were younger. So in summary, Supply-Chain bottlenecks are inflationary, whilst attempts to stimulate demand is creating some specific spikes in price. But rising debt, inflated bubbles, automation and demographics remain structural tailwinds to deflation. We should not mistake an uptick in inflation from very low levels such as we have today with the debilitating inflation of previous eras. Liquidity does not equate to growth or inflation. If administered poorly, it can divert capital into nonproductive channels, lowering future growth prospects. Infinite QE and infinite fiscal could combine to create infinite MMT. But if the economy still has to experience a wave of insolvencies and high levels of unemployment, then the natural pressures will be from the deflationary side with future growth undermined by policies that encourage capital to target asset prices rather than economic inflation.
[00:14:39] One of the areas in which we can see some of the extreme distortions in supply and demand is within the housing market, as we saw in the previous section, U.S. lumber prices have skyrocketed. This does reflect the housing data, which is uniformly surprised on the upside recently. July housing starts increased by twenty two point six percent month on month in July versus an expectation of a gain of only five percent. The rebound off of the very low base had already taken place in last month's data, so this was additive. This rebound has also been repeated in other datasets, confirming the trend. Building permits in July also beat expectations. And again, it's notable that the rebound had already taken place in the previous month. Permits were expected to rebound five point four percent in July, but posted an eighteen point eight percent gain. Existing home sales were equally impressive, registering a twenty four point seven percent rise versus an expectation of a fourteen point six percent gain. And again, building on the previous month rebound. The final corroborative data set is the rebound in new home sales, which increased by thirteen point nine percent boost in expectation for a gain of one point eight percent. Though this one did decline on the previous month, now it is the all these data sets should be taken together rather than treated as four separate indications of strength. So does this reflect a true rebound in the U.S. economy? Clearly, the decline in both interest rates and longer dated yields has helped suppress mortgage costs, making borrowing opportunities look very attractive to those who can afford them. But that's the key, attractive to those who can't afford them. What's mortgage costs are falling for those who have no trouble in accessing them. For a large part of the economy, Cash-Flow, problems are starting to translate into high rates of mortgage delinquency. The rate of delinquency on residential adjustable rate mortgages, which should be benefiting from the fall in yields over the last 12 months, have shot up to the highest level since the great financial crisis. This reflects the unequal access to capital that has afflicted not only the household but also the corporate sector over the last decade in aggregate. The economy may look quite healthy, but scratch beneath the surface and the haves continue to benefit from the access to cheap capital, whilst the have nots are leading to a rise in both zombie households and zombie companies. This is not just a case in the US, but also in the UK, where pent up demand from the pre Covid era, a collapse in mortgage prices and the paying of furloughed staff salaries has created a surge in activity, that caught the property optimists by surprise, with listed offer prices on UK properties increasing by between five and 15 per cent outside London whilst falling in the capital, which is already overstretched. We can see a distortion in the UK's unemployment data as of May, which is admittedly a while ago now. But the UK unemployment rate was still close to a record low of three point nine percent, despite hundreds of thousands of workers becoming furloughed. The big question will be how long can policymakers keep the support packages going and how long will the general population allow themselves to lag even further behind a property boom that is within many countries, primarily the playground of the wealthy rather than that of the average household?
[00:17:57] This has been one of the most unusual years for equity markets in history, or least for the US equity market. A collapse in economic activity led to a dramatic decline in global risk assets, but the emphatic policy response has seen the tech heavy Nasdaq and now the S&P 500 make new all time highs. But as most people know, this has been led by a very small number of stocks. The breadth has been falling, meaning that fewer and fewer stocks are joining in the party at the all time highs. And the latest rally has been taking place on lower and lower volumes. Last week we saw one of the lowest single day volumes on the S&P 500 e-mini future over the last 12 months outside of the four expiry periods during September, December, March and June. Now, you may think that a Summer lull is fairly normal, but David Craig, the CEO of Refinitiv, suggests that this year is particularly striking.
[00:18:48] I think we're witnessing something fairly unusual happening in financial markets this summer. And obviously volumes dip every time around this time of year, but even by the summer standards, we're seeing a highly unusual drop in 2020. We've been looking at our internal numbers on customers use of data relating to S&P 500, which have been grinding higher lately, and it's been doing that on lower and lower volumes. What I think is even more significant is the number of people looking at the data right now, or rather the lack of people. Where volumes are low it may be the case that participants are sitting on the sidelines just watching. By contrast, our usage data suggests they're simply not at their desks right now. The raw numbers really do tell the story. So why is this important? I think if we see a major market event during the summer lull, we may see an outsized reaction. It's just logical that with fewer people around, a big piece of news could be a real move either to the upside or the downside. Simply because potential buyers and sellers aren't there to buy on the dips or sell on the rally. Factor in the VIX index as well, the market's fear gauge, that's about double where it's been in recent summers and you have the potential for quite an exciting and possibly turbulent summer period.
[00:20:04] The point about the VIX index is key. The VIX is a measure of implied volatility. This is what participants are willing to pay for protection. This remeans elevated versus what the S&P is actually doing, which is called historical or realized volatility. Wollman VIX is around 22, whilst 30 day historical volatility is around 10, mainly because the underlying index has been grinding out new highs. And this gap is about twice the spread that we've seen over the last two years. Basically, participants remain cautious and these relatively high costs defined by the difference between implied and realized volatility means that fewer investors will have purchase protection. In an environment where volumes are low and participants are away from their desks gap risk increases. Plus, this could be to the upside or the downside. The fact that we are at the all time highs and short interest is near record lows, it means the risk is probably asymmetric to the downside. Now, this doesn't mean a full reversal is imminent, but we may get the sort of action that we saw in June this year, where the S&P had a short, sharp pullback of around five percent and it washes out the weak hands. So as David suggests, it is definitely worth factoring this into the short term outlook as we head into the final part of the summer period.
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