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Inflation or Deflation?

May 26, 2020

In the past few months there has been a massive fiscal and monetary response to the COVID-19 crisis. The federal government passed a number of COVID-19 relief bills totaling more than $3 trillion mostly funded by government borrowing. The Federal Reserve dropped short-term interest rates to near zero and has once again engaged in a large and broad reaching quantitative easing policy (printing money to purchase assets in order to infuse money into the economy). This has some once again worried about inflation following a decade of persistently low inflation rates. Yet others are more worried about deflation given the damage that has been done to the US economy. How can these fears be diametrically opposed?

To start with, it should be noted that deflation is often far more damaging than inflation. Deflation means the money supply is too low to support economic activity. Money becomes scarce which means its value increases (a dollar buys more than it did in the past as people compete to hold dollars rather than to purchase goods or services or to hold investments). This typically occurs when an economy is highly indebted. When the economy struggles people become more focused on accessing money to pay debts rather than using the money to buy things or invest for the future. If the level of the money supply is insufficient then there will not be enough liquidity (access to money) to cover debt payments leading to defaults, bankruptcies, and falling prices, including a decline in investment prices, wages, and real estate. The 2008-09 recession was the first time this became a serious risk since the Great Depression.

Fortunately, the Federal Reserve understands the risk of rampant deflation and acted quickly to increase the money supply so that debtors may access the money they need to pay their debts. A technical way to look at the economy is Money Supply (MS) times Velocity (V) = Economic Output (GDP). During a recession the Velocity  (the  number  of  times  that  a  dollar  changes hands in a year) decreases as consumers and businesses become nervous and seek to hold on to their cash rather than send or invest. Absent an increase in the Money Supply this would cause a sharp decrease in economic output and possibly lead to a depression. Viewed in this light, the Fed’s actions appear both prudent and necessary given the current economic environment.

So then why is there a fear of hyper-inflation when deflation appears to be a larger threat and more likely scenario given the recent economic slowdown? The risk of hyper-inflation assumes a sharp rebound in Velocity. In other words, it assumes that consumers and businesses quickly return to high levels of spending and investing which stimulates economic activity. No doubt this is a risk, but it should be one that we would welcome as it assumes that the US economy will bounce back quickly. It also assumes that the Fed will be very slow to reverse course and decrease the Money Supply despite a future economic recovery and high inflation rates. In other words, the hyper-inflation scenario is a possibility but it rests on a number of assumptions about the future, some of which may or may not come to fruition.

Given the current economic conditions, the risk of deflation is real. However, there has been a massive government response to address this risk which may or may not be up to the task. In addition, it may take additional action to fully address this risk. Hyper-inflation is a potential future risk assuming the current crisis is properly managed and the current crisis subsides. Should this risk emerge, it will need to be addressed at that time. Arguments that policy makers should act now to avoid hyper-inflation or that investors should change their investment strategy to reflect an environment of hyper-inflation are premature.