Deflation has emerged as a real concern as the economic realities require more understanding. My personal views were the potential of inflation in the medium longer term and interimly being really concerned about deflation because of the credit consequences. Trust me when I say we as the broad public should be terrified of deflation. 

The question's arise as consequences of things becoming much cheaper i.e. oil and consumerables and the knock on effects of company failures, employment and  wage cuts.....we have seen already how this has effected the sporting community and thier incomes.

This article comes from a newsletter I receive and I deliberately left a couple of responses at the end to give you a tone for type of response/s.

Are we again crying wolf on inflation risk in pandemic response?

Now is too soon to worry about inflation from a public policy perspective given the immediate humanitarian need for disaster relief. Many millions of newly unemployed people need cash now to pay bills and just to buy food for themselves and their families. Hesitating to provide help now because of worries about inflation later would be beyond the pale.

Now is too soon, also, to expect to see a rising Consumer Price Index (CPI). Rising unemployment and precautionary savings are currently exerting downward pressure on inflation. Longer term, however, exploding deficits, soaring debt levels, and money printing raises the risk of a toxic bout of inflation. Investors should consider the opportunity provided by declining inflation expectations to diversify into newly cheap inflation-hedging assets.

Falling employment is deflationary

A shocking number of people are losing their jobs. Approximately 17 million people across the United States filed for unemployment insurance during the three weeks ended 4 April 2020, representing almost 11% of the 150 million people working in the US in March (FRED, 2020). Add expected new claims for the week of April 11, and the unemployment rate is likely near 15% and climbing fast. Layoffs and furloughs will continue in coming weeks.

In Australia, the Treasurer Josh Frydenberg has conceded that unemployment will rise to 10% in the three months to June 2020, up from 5.1% in February. The sight of long queues of newly unemployed people at Centrelink offices was a major factor in the massive size of Australia’s stimulus package.

When people lose their jobs, they must immediately cut back discretionary spending. More important, those who keep their jobs reduce spending to increase precautionary savings. This sudden decline in spending reduces aggregate demand more than aggregate supply and thereby puts downward pressure on the prices of goods and services.

Exploding deficits

We must act. Fiscal stimulus is a necessary humanitarian effort to keep our economy functioning through this COVID crisis. By propping up aggregate demand, we aim to prevent a larger than necessary decline in economic output. Failing to do so would risk a depression and profound human suffering.

When tax receipts tumble and government spending soars, deficits explode. Consider tax collections. Income and employment tax receipts are falling alongside declining employment. Sales tax receipts are falling in line with lower spending. Capital gains tax receipts are falling because stock prices have dropped.

How much new debt will be created in the US? Goldman Sachs estimates that the combination of already enacted fiscal stimulus along with additionally required disaster relief legislation will raise America’s deficit to $3.6 trillion this year and $2.4 trillion next year for a total of $6.0 trillion over just these two years (Rosenberg, 2020). Given that the United States was already on track for $1 trillion annual deficit before the COVID crash, that’s a tripling of its deficits.

Who will buy all of this new debt? The Fed will.

Printing money is inflationary

The Treasury is now wiring newly created money directly into people’s bank accounts. Even if ‘helicopter drops’ of cash and the Fed’s buying of $5 trillion worth of newly issued bonds could maintain the nominal value of output and consumption, it cannot prevent the real value of consumption from declining.

Surely, you might think, we should be able to consume more than we produce during this unprecedented crisis. But how can we do so in aggregate? We are not an agrarian economy; eating our seed corn and pepper rations won’t substitute for today’s lost production. Nor will we be able to replace the lost output of goods and services by consuming imports from the rest of the world. All other countries’ output is falling too.

Real consumption must decline in line with the real value of output lost due to the cessation of productive activity. If today’s money printing does succeed in maintaining the nominal value of consumption spending, many more dollars will be chasing a smaller amount of goods and services. The result will be inflation.

Crying wolf

The boy who cried wolf is one of Aesop’s more famous fables. The moral of that story is those who repeatedly make false warnings will be disbelieved when their warnings are finally true. Are we crying wolf about an imaginary risk of inflation?

I don’t think so. I explained in 2015 why quantitative easing (QE) was not then causing inflation and needn’t cause inflation in the future. Quantitative easing creates bank reserves, which do not necessarily increase the money supply. Further, by paying interest on bank reserves, a central bank can effectively discourage banks from using those reserves to create money. I also said:

“Money printing is different from QE. Money printing is inflationary by definition. If the central bank rapidly prints a lot more currency and immediately puts it into circulation, then more money is chasing the same amount of goods and services.” 

To be clear, our worry isn’t about monetary policy conducted by the Fed. We worry about fiscal policy conducted by congress. We worry that future congresses may become addicted to imprudent deficit spending. With the economy at full employment, $1 trillion deficits didn’t cause inflation in 2019. If $4 trillion deficits don’t cause inflation in 2020 and 2021, will congress choose to raise taxes and/or reduce spending in 2022? After the economy recovers to full employment, some level of government spending in excess of tax collections will be inflationary. Inflation is ultimately a political choice.

Is this time different?

On the one hand, lessons learned from austerity in Europe following the GFC warn against failing to provide necessary emergency fiscal stimulus (Fatás, 2018). On the other hand, history also teaches us that if government sends large quantities of cash directly to people for too long, financial crisis and inflation result (Reinhart and Rogoff, 2011).

Will policy nimbly pivot to prevent inflation? The Fed can’t do it alone. Some combination of tax increases and spending cuts following the coming recovery will become necessary to prevent a spike of inflation. Will congress understand precisely when to execute this fiscal U-turn? Will our politicians display the required foresight and courage? I worry.

A future bout of high and volatile inflation may prove to be a toxic side effect of today’s experimental economic medicine. As we approach the coming recovery, investors should be on the lookout for cheaply priced inflation hedges. REITs, small-cap stocks, and commodities have become interesting, and emerging market value stocks look cheap.

 

Chris Brightman is Chief Investment Officer at Research Affiliates. Their long-term forecasts for over 100+ assets across global markets are available on the Asset Allocation Interactive (AAI) tool on the Research Affiliates homepage.

 

 
2 Comments
Peter Bull
April 23, 2020

 

Interesting article Chris. I was just deleting 'inflation' from my dictionary but I'm going to type it back in. Joking aside, I would add a footnote to your footnote. Too often overlooked is the inflation and deflation hedging that can be accomplished within stock selection and even individual companies. Well-timed asset allocation calls are great but they can leave a large dead hand on the other side if things don't go to plan.

 

Geoff
April 23, 2020

 

One factor often omitted is the velocity of money. It has been falling thus reducing the impact of increased money supply. During the GFC we had growth in supply of goods and services. Will that continue in this COVID-19 period? Critically we rely on the Central Banks to manage this money creation and hold back the political impulse to solve every problem with more money. Its just a matter of timing as usual very hard to pick. Inflation will come as we head down this pat

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