Inflation or Deflation? Collapse in Demand Trumps Supply Shocks

Mish

The inflationists are coming out of the woodwork, but they are wrong.

Get Ready for the Return of Inflation, says Tim Congdon, in a Wall Street Journal op-ed.

The economists Milton Friedman and Anna Jacobson Schwartz demonstrated in “A Monetary History of the United States” that a collapse in the quantity of money was the main cause of the Great Depression. Hoping to avoid a repeat, the Federal Reserve in recent weeks has poured money into the economy at the fastest rate in the past 200 years. Unfortunately, this overreaction could turn out just as poorly; history suggests the U.S. will soon see an inflation boom.

Friedman and Schwartz used a broad definition of the quantity of money that included all bank deposits, and found that U.S. money stock shrank by 38% between October 1929 and April 1933. Some prominent economists—including Princeton’s Paul Krugman and Columbia’s Joseph Stiglitz—claim that money growth no longer matters much, but they’re wrong. After all, the 2007-09 recession showed that the ever-changing fortunes of the banking system have a significant effect on demand, output and employment. From 2010-18, growth rates of the quantity of money and nominal gross domestic product were virtually identical at 4% a year.

Policy makers have repeatedly called the battle against the novel coronavirus a war. As in wartime, federal expenditures are rising sharply while tax revenues are being hit by the lockdown. Both World War I and World War II—and, indeed, the Vietnam War—were followed by nasty bouts of inflation. If that happens again, policy makers today being cheered for their swift, decisive action will instead have to answer for their grave lack of foresight.

Inflation View is Wrong

The inflation view espoused above is widely held. Some even call for hyperinflation. 

However, the collapse in demand, dwarfs supply shocks and monetary printing.

The Fed Will Soon Need to Stem Deflation

Economist Tim Duy thinks along the right lines. Duy says The Fed Will Soon Need to Stem Deflation.

It was common early in the crisis to view the viral outbreak as a supply shock because, from the U.S. perspective, it appeared to be largely impacting the flow of goods from China. This original view suggested an inflationary impact from the virus.

The demand-side impact, however, now clearly dominates the economic outlook. Shutting large portions of the economy resulted in a collapse in spending and surging unemployment.  

Not only do we have a collapse in demand, but the eventual rebound in activity is likely to be anemic, too. 

The result will be a protracted, substantial output gap that will weigh not only on inflation but inflation expectations as well. That shift in expectations will weigh on demand. For instance, a student recently asked me if I thought this was a crazy time to buy a car. I said it would be better to wait a few months for prices to come down instead.

What About Wage Pressures?

Duy cited this interesting point from the recent Fed Beige Book of economic conditions. 

No District reported upward wage pressures. Most cited general wage softening and salary cuts except for high-demand sectors such as grocery stores that were awarding temporary “hardship” or “appreciation” pay increases. 

Deflation Summation

  1. Demographics
  2. No wage pressures
  3. Falling demand
  4. Anemic rebound
  5. Eurozone basket case supports the dollar

I find it amusing that people get huge inflation worries out of that mix. 

Inflation Targeting Silliness

But Duy misses the boat too on one point.

Still, watch for deflation concerns to eventually reveal themselves in increasingly strong language reinforcing the Fed’s commitment to a 2% inflation target followed by forward guidance to more strongly lock in expectations that the central bank will not reverse policy easing anytime soon. 

Duy is on the right track, but he failed to blame the Fed.

Very Deflationary Outcome Has Begun

A Very Deflationary Outcome Has Begun: Blame the Fed

Economic Challenge to Keynesians

Of all the widely believed but patently false economic beliefs is the absurd notion that falling consumer prices are bad for the economy and something must be done about them.

My Challenge to Keynesians “Prove Rising Prices Provide an Overall Economic Benefit” has gone unanswered.

BIS Deflation Study

The BIS did a historical study and found routine deflation was not any problem at all.

“Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the BIS study.

Deflationary Outcome

The existing bubbles ensure another deflationary outcome.

Deflation is not really about prices. It's about the value of debt on the books of banks that cannot be paid back by zombie corporations and individuals.

That is what the Fed fears. It takes lower and lower yields to prevent a debt crash. But it is entirely counterproductive and it does not help the consumer, only the asset holders. Fed (global central bank) policy is to blame.

So prepare for another round of debt deflation, possibly accompanied by a lower CPI especially if one accurately includes home prices instead of rents in the CPI calculation.

For a discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?

Inflation targeting is one of the reasons why we are in such a mess for the third time in 20 years. 

Bubbles are Inherently Deflationary

It’s asset asset bubble deflation that is damaging, not routine price deflation.

When asset bubbles burst, debt deflation results.

Here we go again as Hyperinflationists Come Out of the Woodwork Again.

Mike "Mish" Shedlock

Comments (73)
No. 1-26
MericanPatriot
MericanPatriot

Inflation is necessary for Zombie companies and the US to continue to service their debt in a highly leveraged, 0% rate environment absent demand growth. When you can’t cut rates any further, you need inflation to avoid insolvency.

JoeJohnson
JoeJohnson

Money is going into financial markets not into hot pockets. We will see sky high financial assets but hey at least QLVD TVs or whatever you call them will go down in price.

magoomba
magoomba

Anywhere they can enforce inflation they will. This will destroy demand even faster. They will need a brownshirt army to force us to shop. Good luck with that. As they attempt to punish the remaining producers, real shortages will be setting in. These will not be easy to dispel. Then things will get political. Then the meteor comes.

Tony Bennett
Tony Bennett

"So prepare for another round of debt deflation, possibly accompanied by a lower CPI"

...

Absolutely

Massive debt overhang trumps EVERYTHING.

Until dealt with via write down / write off / pay down disinflation (deflation) will be the path. No sustainable inflation. Period.

numike
numike

Ten reasons why a 'Greater Depression' for the 2020s is inevitable
A fourth (related) factor will be currency debasement. As central banks try to fight deflation and head off the risk of surging interest rates (following from the massive debt build-up), monetary policies will become even more unconventional and far-reaching. In the short run, governments will need to run monetised fiscal deficits to avoid depression and deflation. Yet, over time, the permanent negative supply shocks from accelerated de-globalisation and renewed protectionism will make stagflation all but inevitable. https://www.theguardian.com/business/2020/apr/29/ten-reasons-why-greater-depression-for-the-2020s-is-inevitable-covid

wootendw
wootendw

"Fed (global central bank) policy is to blame."

If it's their 'policy' that is to blame (for deflation), what should their policy be other than to dissolve themselves?

CCR
CCR

I am in the supply shock and M1 shock and awe camp to cause buying power reduction before the real deflation occurs, 4-5 years from now. My suspicion is more small businesses will close in the next 6-12 months than expected, across all industries. Banks / governments will be left holding the bag. Loss reserves stacking up on bank balance sheets. Massive individual unemployment checks will continue well beyond expectations.

tokidoki
tokidoki

Japan has been doing this beat for decades. Sure the stock market has never reached previous heights, but they've managed to stave off debt deflation, and it's unclear when somebody is ever going to prick that bubble.

We can do the same.

Herkie
Herkie

I lean towards inflation even as demand is going to remain weak, but then there are many items that have already doubled, tripled, or gone just hog wild, like the $5.99 I paid for less than 2 ounces of hand sanitizer the other day.

My reasons for thinking inflation over deflation are pretty simple: The Fed’s balance sheet, as a percentage of the GDP, is in uncharted territory this year.

But, I am not religiously committed to the position, I recognize that Mish has a better chance of being correct than I do, but one thing we know for sure is it will be one or the other. The economy is not going to magically reopen at the same price levels we are used to.

Part of me wants the deflation because I am on a fixed income. Part of me wants the inflation because I just bought a house and would hate to face a future with no equity. But, I am happy I no longer am on the sucky bad landlord treadmill either.

Zardoz
Zardoz

Production is somewhat automated. Consumption is not. Maybe we'll end up like that old Sci Fi story, The Midas Plague.

gregggg
gregggg

Price deflation for sure at the ground level. It's not like a significant portion of that Federal fairy dust will ever hit the ground near you. Deflation at the upper levels via unpaid loans is going to get much worse.

RonJ
RonJ

"Of all the widely believed but patently false economic beliefs is the absurd notion that falling consumer prices are bad for the economy and something must be done about them."

The other side of falling prices has been the loss of some 60,000 American factories and the good paying jobs that went with them. What has happened to people in the industrial heartland?

Carl_R
Carl_R

There is no question that there is wage pressure. If you try to hire someone, I doubt you will get any applicants at all. People on unemployment collect about $20/hr for nothing, and the requirement that they look for work. Thus, if you have a job that pays $12/hr, you will have to hope you find someone looking long term who realizes that the rich unemployment checks may eventually come to an end.

Meanwhile, there is also a strange market out there, with some items in high demand and short supply (hand sanitizer, food, toilet paper, gaming laptops, etc), where prices are rising, and others where there is way too little demand (e.g. gasoline, used cars), and prices should be falling. In time things will come back into balance, but in the meantime things will get interesting.

I suspect that Mish is right that on the whole prices will fall, but in the middle of that, some prices may well rise sharply, and some items may become very difficult to get.

PecuniaNonOlet
PecuniaNonOlet

Short term, I am in the deflation camp. No one in my family is spending money on anything. Most still have jobs, some have had pay reductions and when I ask what they are doing the answer is the same: nothing. Only my sis-in-law is going out to eat at restaurants, all other fam members eat at home. The fear of catching virus, fear of losing job, fear of running out of money will drive deflation. In Texas, movie theaters are suppose to open Friday, eager to see how many idiots go risk getting sick. Will drive by and report back. Whenever I do go for a drive, virtually all restaurants are empty. Long term: Something has to “break” with all that funny money floating around and the mountain of debt.

Democritus
Democritus

How long can one keep saying 'the idiots at the FED'... It seems more likely to me that they know exactly what they're doing.

amigator
amigator

Good stuff!
Any comments on the gold market especially the last 3-4 days? Looks like my EKG well sort of. Guess its just a normal market nothing going on there!

Casual_Observer
Casual_Observer

Asset bubble isn't bursting from what I can see. This isn't 2008 or 2009. Household and other balance sheets were actually stronger before Covid-19 then before the asset bubble that was the real estate market in the 2000s. This is why this time isn't the same. The rise of China money into the US also has helped. They love to spend cash in North America. This time there is more equity then there was last time so the asset bubble won't burst. There may be a little deflation but it will be followed by inflation.

sangell
sangell

Could go either way. E.G. the Fed increases its balance sheet by $2.5 trillion as asset valuations fall by $2.5 trillion. To the 'money supply' there is no net change. The Fed is merely buying up dead money and replacing it with fake QE money. The problem is a shopping mall is real and represents real consumption of land, labor and capital. QE is an accounting artifice. If the mall has no 'real value' today artificially supporting its price by buying its residue at 100 cents on the dollar adds no real support to the economy.

Jdog1
Jdog1

The ignorance and stupidity surrounding this subject is truly sad.
Not one in a thousand people really understands how our economy works.
Our economy is fiat / credit based. Nearly every purchase is made using credit. The effect of that is that the purchase price of every item purchased on credit is inflated by the amount of interest paid on the purchase.
When an item is purchased on credit, the money for that purchased is created out of thin air (fiat) at the point of that purchase by the buyers promise to pay for that purchase at a later date. The cost of a $100 purchase on a 20% credit card and paid over a year is $120. You created $120 to purchase a $100 item.
Over decades this practice inflates assets faster that wages making the system unsustainable in the long run.
Default on debt destroys money. If you make a purchase on credit you create the money for the purchase. If you default on that debt the money disappears, but the item you purchased still exists.
If this happens on a large scale, the effect is to have a shrinking money supply, and an expanding supply of goods. This is deflation.
The shrinking supply of money makes the money more valuable in relation to the value of assets. The expanding supply of assets causes the value of assets to decline as forced sales require lowering prices.
People who talk about hyperinflation and money printing really do not understand the process. The Fed does not print money, it makes money available to be borrowed.... at interest. It does not matter how much money the Fed makes available if there is no market for new credit. That is why credit lending standards become stricter during recessions. If credit were made too available, and that credit was defaulted on, it only increases deflation because of the additions to the supply of goods, and no increase in money supply because the debt was defaulted on.

I hope this helps people understand.

zirp
zirp

i am in your camp. i do not think this money printing will create any significant monetary inflation.

Nickelodeon
Nickelodeon

IDK Mish, seems like the stage is set for stagflation to me. Maybe it's deflation to start, but the Fed has been very clear that they will create as much money as necessary so I take them at their word....(but in stagflation, some prices go way down while others go way up, so there's that I suppose)

teejaytrader
teejaytrader

Hey Mish... what are your thoughts about the arguments outlined in this video? He makes the case that Peter Schiff is correct and lays out his arguments in great detail. I think it'd be interesting for you to provide a rebuttal to his points in this video...

lasttwo
lasttwo

Interesting Jdog1
So the parasitic cost of interest is the cause of inflation. low interest = low inflation?

Jdog1
Jdog1

Not always, take housing as an example, low interest rates may in fact increase housing inflation. As the interest rates fall, it allows people actually qualify to spend more often purchasing a more expensive home than if interest were higher.

Advancingtime
Advancingtime

I totally agree with Jim Grant, the illusion that inflation as he puts it, is "resting" has been propelled forward by the Fed's policy of low-interest rates and easy money. This does not mean inflation will not awaken with a vengeance.

The hyperinflation that occurred during the Weimar Republic and the speed at which inflation suddenly destroyed the currency dovetails with some of my thoughts on currency trading today. It confirmed that inflation can stem from a growing lack of faith in a currency, or all currencies, rather than just a lack of available goods.

As inflation takes root the goods available for sale often contracts as sellers retreat from the market awaiting higher prices which creates a self-feeding loop. The speed at which this can happen and the fact it could occur across the globe is explored in the article below.

Gnode
Gnode

Surely whether we get price deflation or price inflation will depend on which items we are talking about, and how good times were before we started this mess? What was our jumping-off point?

And there we find really bad news - record levels of consumer debt, for example.

So............most people were already struggling to buy food, let alone new TVs.

Now let's take a straw poll - who here thinks people with barely any money will buy TVs instead of food?

Quite.

You can talk about price deflation in discretionary purchases if you like, as long as we all recognise that there weren't many of these anyway?

TVs can get as cheap as they like, but sausages are still going to the moon.

Of course your friendly government will quietly remove sausages from the inflation basket, and put those cheap TVs in there instead.

And then everyone will be taking about deflation, while we all starve.


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