The Inflation/Deflation Debate: Taking The Over

Summary

• The inflation/deflation debate boils down to whether the surge in government bond issuance and money printing will continue to be offset by an even greater increase in money hoarding.
• The rise in the ratio of money supply to GDP (so-called declining velocity) reflects a rise in potential inflation rather than an argument for deflation.
• The inflation outlook will also depend on which members of society receive the additional supply of money.
• With the prospect of additional and larger stimulus check issuence gaining momentum, money looks set to increasingly flow into the hands of those with a greater propensity to spend it, suggesting inflation pressures will rise.

Macroeconomists are split on the key issue of inflation versus deflation and there are valid arguments being made on both sides. The debate ultimately boils down to whether the surge in government bond issuance and money printing will continue to be offset by an even greater increase in the willingness of individuals and businesses to hoard cash. This in turn will depend on which members of society receive the additional supply of money. With the prospect of additional and larger stimulus check issuance gaining momentum, we think the odds are heavily stacked in favor of rising inflation.

Deflation arguments tend to focus on a collapse in demand that will offset the impact of rising money supply growth. However, while the growth of a certain good is driven by demand for that particular good, the demand for all goods and services in an economy is infinite (people will always want more stuff). This is the essence of economics: how to satisfy infinite demand with finite resources.

Inflation is not driven by 'demand' but by spending, which is driven by the amount of money that people have and their willingness to exchange it for goods and services. For any given level of goods and services available in an economy, the greater the amount of money people have, all else equal, the higher prices will be. This means that the fewer goods and services that are produced relative to the amount of money, the higher prices will tend to be. This is not a difficult concept to understand at the individual product level; just look at the price of PPE equipment and hand sanitizer in recent months. It is no different at the economy-wide level. Too much money chasing too few goods will lead to higher prices.

Lockdowns Have Led To Temporary Involuntary Hoarding

The current economic climate should theoretically be highly inflationary, then. A contraction in the availability of goods and services combined with a rapid increase in the supply of money is the ideal recipe for inflation. However, one crucial factor to consider is the demand for money. There has been a temporary period during lockdowns when people have simply been unable to spend the money they have of many things they would otherwise want to spend it on. Even amid a surge in the availability of money and a collapse in the availability of goods and services, if individuals and businesses hoard the money as a store of value to buy goods and services in the future rather than today then this can overwhelm the direct inflationary forces.

However, this is highly unlikely to last given the sharply slowing rate of new COVID-19 cases. Even if lockdowns are extended longer than expected, the ratio of money supply to GDP will continue to rise as policymakers respond to economic weakness with fiscal and monetary stimulus measures, which will store up greater inflation potential for the future once this money is spent. M2 money supply has surged by almost 2T since the beginning of March - a 100% annualized increase - at the same time as real GDP has fallen. Over the coming months and years we are likely to see this new money get spent, driving up prices.

Declining Velocity Is Actually Rising Potential Inflation

The demand to hoard money as a store of wealth is often mistakenly characterized as the velocity of money, defined as the number of times that the average unit of currency is used to purchase goods and services within a given time period. In reality, inflation has absolutely nothing to do with how often money changes hands. A great article by Frank Shostak explains the failings of the notion of money velocity here, quoting the godfather of Austrian economics Ludwig von Mises:

The mathematical economists refuse to start from the various individuals' demand for and supply of money. They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics. - Ludwig von Mises

Deflationists often point to the chart below of the declining ratio between M2 and nominal GDP (the so-called velocity chart) as evidence that inflationary pressures will remain weak despite the rise in money supply. However, we think it is more appropriate to view this ratio the other way round and to interpret it as a surge in potential inflation.

The rise in the ratio of money supply to GDP reflects a rise in potential inflation as there is no guarantee that individuals and businesses will continue to increase their desire to hold money as a store of value. Given the huge rise in the stock of money relative to the size of the economy, and the high likelihood that money supply will continue to rise sharply, it would only take a slight decline in the willingness to hoard this money to see prices rise sharply.

The outlook for inflation will ultimately depend on whether we see a surge in the demand for money as a store of wealth offsetting the inflationary force of money supply continuing to exceed real GDP growth at an increasing clip. This seems highly unlikely to us.

Who Gets The Money Will Be A Crucial Determining Factor

To understand whether the rise in money supply relative to the availability of real goods and services will lead to rising prices we need to understand who will actually end up holding this money. If, as was overwhelmingly the case following the Global Financial Crisis, the increase in money ends up in the hands of the wealthiest members of society, there is no guarantee that it will be spent as wealthy individuals and businesses have a much lower propensity to consume. If, on the other hand, the money increasingly finds its way into the hands of poorer members of society with a higher propensity to consume, we will likely see a surge in prices of everyday goods and services. Our view is that stimulus measures will become increasingly generous, resulting in a greater share of money in the hands of people willing to spend it. The proposal to give USD2,000 per month to every American age 16 and older who earns less than USD130,000 a year for at least six months is reportedly gaining steam. If such a policy is enacted we are likely to see inflation rise dramatically.

Analyst’s Disclosure: I am/we are long RINF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[CyrusCynthia]

I like your article, the risk of inflation is what if people don't have money to spend? A lot of printed money will stay in the system creating an even bigger asset bubble down the road. However virus puts a deep cut into economy probably by fixing it FED&Gov overdo it. I learn that day after day from the Mr. Market.

[Stuart Allsopp]

I see your point about how printed money will stay in the system. However, this 'money' is already entering the system via the massive deficits.

[CyrusCynthia]

What I mean is looking back since GFC QE is not very effective in creating inflation, until researchers realized one unexpected result is asset bubble. As long as large part of new money stay in the financial system, inflation can be low.

[Stuart Allsopp]

I think the big difference between now than the GFC is that there are now virtually no contraints on government deficits. This is the ultimate cause of inflation. All QE does is allow CBs to run deficits without interest costs rising.

[Lawrence J. Kramer]

"The debate ultimately boils down to whether the surge in government bond issuance and money printing will continue to be offset by an even greater increase in the willingness of individuals and businesses to hoard cash."

If that's the debate, maybe we should get new debaters. The debate ultimately boils down to whether the surge in money printing (which includes the issuance of bonds AND the Fed's purchases of bonds) will overwhelm the available supply of goods and services on which it is spent. "Money-hoarding" is one way to describe the failure to spend, but given that so many people "spend" by short-term borrowing (credit cards), the demand for goods seems a more important parameter than the holding of cash.

The problem with this exercise is that demand and supply have both been disrupted by the pandemic. Prices may rise more from shortages than from money-printing. If no money were printed, more people would have to do without staples, so some part of the price rise is attributable to people having SOME government money, but the whole way we distribute things is thrown into a cocked hat when everyone who does not make a necessity is out of work. We need a more manna-like distribution while we wander in this economic desert, and that's what helicopter money provides. With the normal economic forces sidelined, the whole question of "inflation" or "deflation" seems beside the point. We gotta do what we gotta do.

[Hiro Protagonist]

I have come to believe that a 6-10 year dictatorship with LJK in the big chair would be exactly the sort of hard reset of the republic that we need (as far as I know, none of the Roman dictators overthrew the republic until Julius, and he didn't wear the title "dictator" when he crossed the Rubicon).

[David de los Ángeles Buendía]

Hello @Lawrence J. Kramer ,

I would argue that the main driver for inflation is demand and that demand for goods and services is falling significantly. The supply of goods and services may yet fall but is currently in excess of demand. This will put downward pressure on prices. The increase in the supply of narrow money will no doubt create inflationary pressures but it is unclear that this will be greater than the deflationary pressures of collapsing demand.

[Lawrence J. Kramer]

"I would argue that the main driver for inflation is demand ... "

I lean toward Friedman's view that inflation is a monetary phenomenon. I would watch the value of the USD against other currencies as the best measure of inflation when macro forces like those now in play are affecting supply and demand so dramatically.

[David de los Ángeles Buendía]

Hello @Stuart Allsopp ,

Inflationary and deflationary pressures on prices exist all of the time. Prices fall or rise depending the balance of those forces. When the supply of goods and services exceeds the demand, deflationary pressures generally dominate and when demand for goods and services exceed supply, inflationary pressures generally dominate.This is not principally an issue with a simple increase or decrease in the supply of money. What drives an economy is the creation of goods and services and the exchange of those commodities for other goods and services, mediated through money. Money is simply the medium of exchange, it is like lubricant in an internal combustion engine. The engine turns because petrol and air and burnt, the motor oil just helps that process move smoothly. The lubricant does not turn the crank shaft. Economic growth is principally about capital creation and the production of goods and services with monetary policy being the handmaiden.

What is happening right now is that the economic engine has no fuel because of the corona virus. Too much or too little supply of money and credit are not the problem. I would note however this has been the general situation for a few decades now. With the export of manufacturing capital, the main agent of growth, inflationary pressures have been very low. Deflationary pressures have generally been dominant since the 1980's although it has only rarely expressed itself by falling prices. This where monetary policy has played a key role is in combatting the outright fall in prices. By expanding the supply of narrow money (M0), in Japan since the 1990's, in the United States and Europe since 2008, and now everywhere in the world, inflationary pressures are created, which have generally balanced the deflationary pressures, keeping prices more or less stable. Without Quantitative Easing, deflation would have dominated and prices would have fallen.

[Hiro Protagonist]

@David de los Ángeles Buendía:
"With Quantitative Easing, deflation would have dominated and prices would have fallen."

I think you meant "Without Quantitative Easing"

Might I ask, what is your personal forecast for inflation / deflation Mr. Buendia? Obviously it is impossible to know, but I imagine you have your own ideas that go a little beyond simply extracting the market's inflation expectation from the pricing of TIPS vs. same-duration vanilla treasuries.

[David de los Ángeles Buendía]

Hello @Hiro Protagonist ,

1) Yes, just so, thank you.

2) Let me say that the United States, and indeed the entire world, is in an unprecedented monetary and economic situation.

3) Inflation expectations [1] [2] have been low but stable whilst the deflation expectations have increased [3]. The volume of narrow money has increased quite dramatically [4] and may well increase even more. However over all economic activity is declining even more dramatically [5]. I would be willing to guess that at the moment deflationary pressures are dominant.

However, I suspect that the Federal Reserve Bank, and other central banks, will do all that they are able to do to ensure that inflationary pressures will at least equal deflationary pressures.

[1] fred.stlouisfed.org/...

[2] fred.stlouisfed.org/...

[3] fred.stlouisfed.org/...

[4] fred.stlouisfed.org/...

[5] fred.stlouisfed.org/...