In the depths of the global financial crisis in late 2008 and early 2009, we saw numerous financial commentators simultaneously warn of the risks runaway inflation and depressionary deflation. In the past couple weeks, we have started seeing this phenomenon rise again in financial publications we regularly monitor. MarketMinder Europe addressed the runaway inflation issue at the end of April. More recently, deflation seems to be gaining primacy in financial headlines, with the Organisation for Economic Co-operation and Development’s (OECD) announcement on 5 May that global inflation fell by the most since the financial crisis in March.[i] In short, whilst investors have myriad risks to grapple with right now, deflation shouldn’t be one of them, in our view.
The popular deflation narrative we have observed in a number of financial news outlets holds that growing economies and rising inflation go hand in hand, with gradually rising prices helping spur demand. In contrast, crises like the institutionally induced, worldwide economic shutdowns to contain COVID-19 destroy demand, driving retailers and service providers to slash prices. That then supposedly creates a vicious circle in which consumers perpetually don’t spend in anticipation of a better deal whilst sellers repeatedly discount, sending prices lower and lower. This feared deflationary spiral would then result in the type of economic weakness seen during Japan’s so-called Lost Decade of stagnant economic growth and falling prices in the 1990s or the United States in the early 1930s.
In our view, the problem with this theory is that it doesn’t account for what drives prices. Inflation, as American Nobel prizewinning economist Milton Friedman argued, is a monetary phenomenon of too much money chasing too few goods. Deflation, then, is the opposite—not enough money chasing too many goods. In either scenario, the key variable is money supply. History bears this out, in our view. In the early 1930s, a series of errors by the US Federal Reserve (Fed) caused money supply to plunge, as Friedman and Anna Schwartz documented in their classic work, A Monetary History of the United States, 1867 – 1960. The modern money supply measure most analogous to what they displayed is M1, which the Fed describes as including bank notes, coins, bank reserves and checkable deposits. As policymakers took money out of the financial system, capital dried up, which Friedman and Schwartz’s research showed diminished investment and consumption. We think the full range of circumstances and data show deflation was a symptom of this destruction, not the cause.
The latest inflation data available for the UK is March’s Consumer Price Index (CPI), and it was flat on a month-to-month basis.[ii] Core CPI—which excludes more volatile food and energy categories —rose 0.2% m/m, suggesting falling oil and gas prices (which heavily impacted transport services) weighed on the headline reading.[iii] However, declining clothing and footwear prices detracted, too—consistent with anecdotal evidence of discounting among major retailers, which we have seen documented throughout financial news coverage.[iv] Moreover, the UK’s April services Purchasing Managers’ Index (PMI) also noted deepening price discounting last month, so a further price slide wouldn’t shock us.[v] However, massive discounting as businesses try to move product whilst stores are closed isn’t a lasting deflation. Nor is the discounting that seems quite likely when high-street stores reopen and have a glut of out-of-season merchandise to offload. These aren’t positive developments for retailers and shop owners, but we think they are a symptom of the lockdown’s economic fallout, not the beginning of entrenched deflation.
The evidence strongly suggests central banks like the Bank of England (BoE) and Fed aren’t taking money out of the economy—a prerequisite of deflation as seen in the early 1930s. Major money supply measures are jumping. In the UK, M4—the broadest gauge of money supply, which includes all bank notes, coins, deposits, money market funds and other securities that can function as a monetary medium of exchange—jumped 8.1% y/y in March, its fastest rate since April 2017.[vi] In the US, which produces more timely weekly data, we also see evidence of abundant capital. M1 growth is running in the double digits on a year-over-year basis.[vii] So is broader M2, which includes M1 as well as savings deposits, money market funds and certificates of deposit (CDs).[viii] These developments quite likely won’t stop prices from falling in the near term as businesses try to clear inventories, but we think they should keep money moving through the economy and ensure businesses have access to capital. In our view, the primary change that will enable a new economic expansion is the reopening of businesses, but when that happens, rising money supply should ensure businesses and consumers will eventually have plenty of firepower—just as it did after the 2008 – 2009 global financial crisis, when deflation fears also proved false.
Whilst we often see headlines focus on how prices are moving, inflation and deflation trends don’t drive the economy, in our view. We view them as one very loose indicator of whether money supply is growing fast enough to meet the economy’s needs. Sluggish inflation can signal tightness in lending markets, as we think it did for much of the last US expansion, when our research shows Fed’s long-term asset purchases flattened the yield curve. The yield curve is a visual representation of a single issuer’s interest rates across a range of maturities, and we think it is a loose indication of bank lending’s profitability, as banks borrow at short-term rates and lend at long-term rates. A flatter curve, in our view, diminishes the incentive to lend and can therefore act as an economic headwind.
Fast inflation can signal too much money sloshing around the system, raising the risk of overheating. Deflation, as we mentioned earlier, is sometimes a sign there isn’t enough money. Other times, falling prices many equate with deflation are actually a sign of rapid innovation driving vast productivity growth.[ix] Prices overall fell in America during much of the second industrial revolution.[x] Similarly, the UK has dealt with its own fair share of inflation and deflation concerns. From 2014 – 2016, deflation worries were common amongst financial commentators after plunging oil prices sent CPIs globally lower.[xi] Then in late 2016 – 2017, those worries shifted into projections of runaway inflation driven by a Brexit-induced weakened pound sterling. Yet despite myriad analyses dissecting what UK inflation was allegedly saying, it didn’t reveal anything about growth, economic conditions or the future—GDP growth continued as the inflation rate sped and then slowed.[xii] In all these scenarios, we think the data show prices are an after-effect. Moreover, to see that after-effect clearly, we think investors benefit most from assessing broad trends and not fixating on any one monthly reading, especially when those monthly readings are subject to skew from extenuating circumstances.
In our view, inflation (and deflation) data are at best coincident, often skewed by short-term factors and usually the product of other trends. We have seen little to no evidence they reliably predict economic direction. So if you hear arguments touting the signals CPI is supposedly sending to consumers—and what all that means for growth—we suggest approaching the conclusions quite sceptically.
[i] “Inflation Collapses Around the World Amid Coronavirus Pandemic,” Richard Partington, The Guardian, 5 May, 2020.
[ii] Source: Office for National Statistics, as of 12/5/2020.
[v] Source: IHS Markit, as of 12/5/2020.
[vi] Source: Bank of England, as of 12/5/2020.
[vii] Source: St. Louis Federal Reserve, as of 12/5/2020.
[ix] “Falling Prices Aren't ‘Deflation.’ They Instead Signal Booming Growth,” John Tamny, RealClearMarkets, 4 May, 2020.
[x] “Deflation and Depression: Is There an Empirical Link?” Andrew Atkeson and Patrick J. Kehoe, Federal Reserve Bank of Minneapolis, January 2004.
[xi] Source: FactSet, as of 13/5/2020. Statement based on crude oil prices (Brent global spot price) from 23/6/2014 – 20/1/2016 and year-over-year change in UK CPI, eurozone harmonised CPI and US CPI, June 2014 – January 2016.
[xii] Source: Office for National Statistics, as of 12/5/2020.
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