In the depths of the global financial crisis in late 2008 and early 2009, an odd thing happened: People simultaneously feared runaway inflation and depressionary deflation. In the past couple weeks, we have started seeing this phenomenon once again. The former we addressed last week. Lately, deflation seems to be gaining primacy, with the OECD’s announcement Tuesday that global inflation fell by the most since the financial crisis in March, making this a good time for us to weigh in. In short, while investors have myriad risks to grapple with right now, deflation shouldn’t be one of them, in our view.
The popular deflation narrative holds that growing economies and rising inflation are sympatico, with gradually rising prices helping spur demand, while crises like the present destroy demand, driving retailers and service providers to slash prices. That supposedly creates a vicious circle in which consumers perpetually hold out for a better deal while sellers repeatedly discount, and before you know it, we are Japan during its lost decade or the US in the early 1930s.
In our view, the problem with this theory is that it flat out ignores what drives prices. Inflation, as Milton Friedman summed it up, 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. In the early 1930s, a series of Fed errors caused money supply to plunge, as Friedman and Anna Schwartz documented in their classic work, A Monetary History of the United States, 1867 – 1960.[i] 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 sucked money out of the system, capital dried up, wrecking investment and consumption. Deflation was a symptom of this destruction, not the cause.
The latest inflation data available for the US are March’s Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) Price Index. Both fell on a month-to-month basis.[ii] So did the “core” measure of each index, which excludes food and energy, so falling oil and gas prices weren’t the sole contributor.[iii] We have seen piles of anecdotal evidence of discounting among major retailers, and Purchasing Managers’ Index price gauges fell in April, so a further price slide wouldn’t shock. However, massive discounting as businesses try to move product while stores are closed isn’t a lasting deflation. Nor will the discounting that seems quite likely when brick-and-mortar stores reopen and have a glut of out-of-season merchandise to offload. These aren’t positive developments for retailers and shop owners, but they are a symptom of the lockdown’s economic fallout, not the beginning of entrenched deflation.
We are confident saying this because, unlike in the early 1930s, the Fed isn’t yanking money out of the economy. Major money supply measures are jumping, as we covered last week. M1 growth is running in the double digits on a year-over-year basis.[iv] So is broader M2, which includes M1 as well as savings deposits, money market funds and CDs.[v] This won’t stop prices from falling in the near term as businesses try to clear inventories, but it should keep money moving through the economy and ensure businesses have access to capital. We still think the only thing that will enable a new economic expansion is the reopening of businesses nationally, but when that happens, rising money supply should ensure businesses and consumers will eventually have plenty of firepower—just as it did after the financial crisis, when deflation fears also proved false.
Despite pundits’ dalliances with it, inflation and deflation trends don’t drive the economy. They are 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 it did for much of the last expansion, when the Fed’s long-term bond purchases flattened the yield curve. 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 a sign of rapid innovation driving vast productivity growth, as John Tamny illustrated at RealClearMarkets on Monday. Prices overall fell in America during much of the second industrial revolution. This told you next to nothing about growth, economic conditions or the future. In all these scenarios, prices are an after-effect. Moreover, to see that after-effect clearly, you must assess broad trends, and not get hung up 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. There is little to no evidence they reliably predict economic direction. So if you hear someone touting the signals CPI or PCE are sending to consumers—and what all that means for growth—we suggest approaching the conclusions quite skeptically.
[i] As former Fed head and then-Fed Governor Ben Bernanke put it in toasting Friedman in 2002, “You’re right, we did it.”
[ii] Source: St. Louis Federal Reserve, as of 5/5/2020.
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