Inflation or Deflation?

April 27, 2020

As the aftermath of the COVID-19 pandemic unfolds, the debate about the onset of deflation rages once again . . . or is it inflation?   The two camps continue to face off, each with a compelling arsenal and the battle is fraught with uncertainty.

While most individuals and businesses are generally oblivious to the consequences of either outcome, the outcome is very meaningful and pain will be felt if you are ‘positioning’ on the wrong side of the argument.   Here are some highlights of what to expect.

Inflation – In periods of inflation, asset prices rise and costs for goods and services rise with them.   The value of money declines along with the ‘burden’ of debts (the debt becomes smaller in relation to income and/or assets).  Owning hard assets that can be traded later for inflated currency will benefit patient owners.   For the frugal who save money, hoard currency and avoid the risks of investment in hard assets, the value of that currency will be reduced.

Deflation – Deflation is the process of reducing the value of assets thereby increasing the power (value) of money.   Hard assets will be reduced in value.  Historically during periods of deflation, debtors have been forced to sell assets, often with significant losses and are burdened with unmanageable debts.  Those who save money frequently have increased financial power due to there savings.

As you consider the implications for your personal life, business or the future of government, there are a few macro issues to consider.  Most prominent of those is that being a debtor is now the most prominent approach to personal, business and government methods.   In Canada, just 29.6% of the population was debt free in 2016 according to stats Canada (keep in mind that about 16% of the population are under 15 years old).  Yet studies have shown that 47% of Canadians are barely able to cover costs, primarily due to excessive debt.   In the US, the numbers are even worse, with about 80% of Americans in debt and half of the country being just one paycheck away from financial hardship.  The net of that is that inflation is the ‘best’ course of action for most participants in the economy.

There is plenty of evidence that inflation is not coming back quickly, however.   The general trend for the past thirty years has been downward, and the current crisis is expected to reduce inflation even further in the short term.   The crash of oil prices is just one example of likely reductions in the price of key components of consumer demand and it highlights the deflation argument.

US Inflation 1990-2019

While deflation is good for savers, it is not good for those heavily in debt.  When prices fall consistently, individuals tend to hold off on purchases in the hopes of getting a ‘better’ price.  But the burden of high debt levels slow down national economies as tax dollars are allocated to make payments to service the debt, making less available for growth and maintenance of infrastructure.

Given the importance of inflation to economic health, it is clear why governments want to spur inflation, yet keep it at manageable levels.   The Bank of Canada targets 2% inflation as does the US Federal Reserve, with similar targets for the EU, Japan and other nations.

The arguments for inflation have been predominant for years.   During the last financial crisis governments increased national debts massively and through monetary operations forced interest rates to near zero in North America and below zero in other parts of the world.   Historically, making massive amounts of money available with very low interest rates has been a recipe for excessive inflation.

It didn’t happen.   This has baffled central banks, but there is general acceptance of lower inflation even with very high sovereign debt.   In a recent article the New York Times highlighted the Fed’s shifting view on inflation. Japan, with the highest debt to GDP in the world has lived with decades of stagnant growth and inflation.   The Japan example is particularly worrisome to many as the stagnation in their economy has not resolved anything.   The excessive debt has not substantially changed measures of ‘life’ such as productivity or quality of life.

Public debt to GDP levels in Canada (108%) are higher than those in the US (71%), and the importance of the US as a trading partner make our problem more acute.   Canada remains intimately tied to the health of the US economy, particularly in the auto and oil sectors.

Without inflation, a deflationary spiral becomes more probable, where prices fall for a long period, economic risk rises.  As risks escalate, capital is hoarded and borrowers may need higher returns on capital to initiate projects, which reinforces the declines in spending.   The problem can last for years (Japan has been stagnant for 30 years, but has not suffered a deflationary spiral). With inflation, the value of money is eroded while incomes, in theory, rise and debt is minimized while asset prices go up.

It is too early to tell which way the economy will go.   Early evidence of deflation may be ‘transitory’ as the economy reels from the COVID-19 crisis, but as aggregate income is reduced, there will be downward pressure on consumption and prices that lasts far longer than many thought just a few weeks ago.   Meanwhile the massive amounts of debt is forcing money into the system which should spur, or at least help to sustain, demand.   One lesson from the 2008/2009 crisis was that quantitative easing really only served to raise asset prices (stocks, real estate, bonds) and most evidence suggests that it dramatically widened the gap between the wealthy and the average.  Despite that, it looks to be the method being followed in the current crisis as well.

Perhaps the best solution is an approach that covers most of the bases.   Typically there are three areas that you want to protect:  (1) your survival in case of a disaster, job loss or other unplanned events; (2) income to cover your immediate expenses and (3) your wealth, which for most is ensuring your assets rise and fall with the general economy.  These are repeated below with a bit more detail.

  • Your rainy day fund.   The economy continues to run, with ups and downs as it always has.   Difficulties for many revolve around three problems.  (a) too much leverage; (b) lack of income; (c) disasters.   A rainy day fund that can cover substantial losses reduces these risks.  Of course insurance companies are happy to sell you products to mitigate these risks but if you have ample financial flexibility then your risks will be substantially lower. (Significant changes in the economy such as COVID-19 usually mark the onset of deflationary and inflationary activity.   It is these periods of uncertainty that require a rainy day fund.  Keep in mind that money loses value during inflation and gains value in deflation.  Too much cash is not overly helpful.)
  • Income is critical.   While income for the lowest 50% of wage earners typically doesn’t leave much for saving, it does reduce the need to increase debt or decrease savings.   Keeping income whenever possible will reduce economic risk.  (wages generally follow the economy, up in good times, down in bad times, and provide protection against rising prices.)
  • If you have excess funds putting them into hard assets or assets that are backed by solid fundamentals such as a home, sound businesses (think TSX index or S&P index ETFs) and if you follow older bellweathers, perhaps some gold, silver etc.  (This includes mining companies that make base and precious metals as a proxy for actually owning metals.  Companies are productive, while metals provide no income and may be difficult to acquire, store, transport and sell).  (these will rise in value during inflation and fall during deflation, but if you are not over leveraged, these trends cover long periods).

For the sake of the majority, inflation will hopefully show up, but in the near term, assets that have been boosted by central government purchases in this and the last financial crisis are prime for a deflationary reset.

Here are some views by leading thinkers on what lies ahead.

 

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