Inflation seems to be the central theme in markets currently and much focus is being placed on the inflation vs deflation debate. This debate has many factors that need to be considered and can be thought of as a bit of a balancing act between them all. With the recent Covid induced inflation (see chart below) and responses by world governments, many believe that we are moving into a new inflationary regime. Regardless of whether you reside in the deflation or inflation camp, it is important to assess both sides of the debate.
The deflation case:
Disinflation has been the predominant trend of the past few decades, driven by some key fundamental factors.
One of these factors has been the globalisation of the world economies. When countries around the world joined the global economy and created the international markets we have today, they also got the benefit of sourcing cheaper labour and resources. Similarly, globalisation also increased competition by giving customers access to a global array of companies, products, services, and technologies. The combination of access to cheaper labour and increased competition both resulted in a decline in the cost of many goods and services.
Another key factor has been the rapid growth in technology. The digitisation and innovation brought about by technology have increased productivity and efficiency dramatically. This increased productivity through the substitution of labour (automation) and cheaper substitutes has been driving down costs for decades.
The above factors are the predominant reasons for the disinflation that has been experienced in many developed economies in the past. However, given the extraordinary conditions that we have all experienced recently, there are a few other factors to consider.
The pandemic and never-ending stimulus that followed have caused the debt levels of many countries to inflate to unsustainable levels. This would not be a problem if this debt earned a return that exceeded the cost of it, in other words, if there was high marginal productivity of debt. The problem that we are experiencing is that the stimulus-induced debt has not been used in the most productive way (handing out free cheques to the population is hardly putting the money to productive use) and thus the marginal productivity of debt has fallen. In fact, it has decreased to its lowest levels in years and thus instead of the debt enhancing economic growth it could land up undermining it.
Many believe that the stimulus has caused an increase in the money supply and with it the velocity of money. However, before going on, it is worthwhile explaining the structure of the money supply and how new money is created. Many believe that the Federal Reserve can increase the amount of money in circulation, this is untrue, the Fed merely creates reserves (called deposits), for commercial banks to lend against. New money is only created once commercial banks decide to make loans to the private sector. Thus, if commercial banks don’t lend against these deposits, then no new money is created.
The loan-to-deposit ratio (below chart) compares the number of loans made to the private sector against the total deposits on the commercial banks’ balance sheets – as you can see, this ratio is pretty much at an all-time low. The reason is that the risk of lending to the private sector (partly due to the abovementioned debt and economic downturn) has raised risk premiums to levels where commercial banks are unwilling to lend. This shows that although the Fed has printed new money, this money is not being circulated into the private sector as the banks are reluctant to loan. This lower level of lending not only suppresses the money supply but also leads to a lower velocity of money (the frequency/speed at which money is exchanged between market participants). This is evidenced by the below chart showing both M2 money velocity as well as the loan-to-deposit ratio hitting all-time lows.
Anyone who has done economics will know that the percentage change in GDP is a function of both the money velocity and the amount of money in circulation (high supply + high velocity = higher GDP growth). Thus, with both money supply and velocity being suppressed, GDP growth will most likely be lower and result in deflationary pressure.
Overall, the main point for team deflation is that the world is mired in a debt trap whereby one dollar of government-issued debt is reducing GDP not increasing it, therefore hindering economic growth. On top of this commercial banks are less willing to lend due to increased risk in the private sector which has suppressed both money growth and velocity, which will again suppress economic growth and magnify the deflationary pressures.
The inflation case:
There has been a lot of discussion about the possible shift to a new inflationary paradigm. There is little doubt that the current inflation is primarily driven by supply bottlenecks brought about by Covid, however, these pressures are likely to subside in the future. There are however longer-term pressures forming and the chief factor for the inflation case is undoubtedly the huge amounts of stimulus being provided and its effect on the money supply.
As noted above, however, an expansion in the M2 money supply does not constitute an increase in new money – we need commercial banks to make loans against the deposits. The inflation argument stems from governments’ response to the pandemic whereby they have guaranteed loans to the private sector – effectively backing any loans that default in the private sector. These government guarantees (if done on a large enough scale) would solve the abovementioned problem of commercial banks not lending due to high-risk premiums as now suddenly, the risk of lending has diminished due to government backing. This would allow commercial banks to issue loans at will and cause new money to flood the economy and dramatically increase money velocity. This in turn would spur economic growth – essentially there will be more money chasing fewer goods – which by nature would be inflationary.
Another cited reason from the inflation camp ties back to the overbearing amount of debt at the government level. Debt levels being so elevated gives governments reason to keep interest rates artificially low. The reason is that should they allow yields to rise too much, then the US and most other developed governments could default as their interest payments would balloon to unsustainable levels. Thus, by keeping yields low they could reign in the interest on their debt, but at the same time could cause the economy to overheat and inflation to ensue.
Alongside the abovementioned inflation forces, many economists have accepted that some of the global forces that have held down prices for so long are dissipating – a trend that has likely been exacerbated by the pandemic.
Globalisation, which has been one of the most deflationary forces in the past, peaked back in 2008 and has been stagnant ever since (measured by world trade as a percentage of GDP). Whilst globalisation is most definitely not dead, the dynamics have most certainly changed. Between ongoing trade wars and increasing protectionism, you can clearly see this changing trend. The pandemic has also made many economies realise that over-reliance on global supply chains has consequences and thus we may see globalisation begin to slow further. This means that the benefits of cheap inputs sourced globally could slow down causing long-term inflationary pressure.
In summary, increased lending being compelled by government guarantees would allow the velocity of money to increase and further exacerbate the debt problem. This in turn would cause governments to keep yields artificially low which coupled with structural changes in the global economy would all contribute to long-term rising inflation.
Overall, regardless of whether you are a believer that inflation or deflation is to come, it is prudent to understand the factors affecting both sides and position yourself accordingly. Managing risk is of the utmost importance when navigating uncertain times and that is where we at Global & Local Asset Management use the “Avoid the Human Factor” strategy to manage our collective investment scheme portfolios. The strategy focuses on managing portfolios like an actuary and not a portfolio manager.
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