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Who Will Win the Tug of War: Inflation or Deflation?

Published by Tavex Analysts in category Market News on 12.07.2023
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In today’s economic landscape, the question of whether sustained inflation or deflation is on the horizon has become a critical topic of discussion. Prominent economist and investment banker, Jim Rickards, highlights the significance of this debate and its far-reaching implications. This article delves into the complexities surrounding the trajectory of inflation and deflation, challenging the traditional economic narratives and forecasting models.

Can the upward trajectory of inflation be sustained? Will there be another slowdown or perhaps deflation? According to Jim Rickards, an economist and investment banker, this is maybe the most important topic in the economy right now.

Can you anticipate sustained inflation — or a trend towards disinflation, if not deflation?

That is, without a doubt, the most significant question in economics today.

This is more than just a clash of narratives. The question is central to current economics (the so-called Neo-Keynesian consensus) and economic forecasting models.

In reality, it gets to the core of economics and helps to explain why so many projections are so off.

The story of inflation is plain. Inflation began to rise in mid-2021 and reached 40-year highs in June 2022. Inflation peaked at 9.1%, a level not seen since the early 1980s. At the same time, unemployment was nearing 3.4%, a level not seen since the late 1960s.

This combination of high inflation and low unemployment appeared to validate the Phillips curve, which proposes an inverse relationship between inflation and unemployment. Inflation is high while unemployment is low, and vice versa.

The Argument for Inflation

The story of deflation, which includes disinflation, is likewise simple. The Federal Reserve got more concerned about inflation by late 2021 and decided to take action. In early 2022, the Fed began tightening monetary policy by not rolling over expiring mortgages and US Treasury securities, lowering the base money supply.

They tightened much further with a programme of ten consecutive interest rate rises beginning in March of last year and lasting through May of this year. (The Fed skipped a rate rise in June 2023 but is leaving the possibility of raising rates further on the table for the time being.) The Fed’s policy rate was raised to 5.25% as a result, one of the quickest rises of that scale in Fed history.

The Fed’s monetary tightening appeared to be effective. In May, inflation fell from 9.1% in June to 4.0%. That’s still significantly beyond the Fed’s 2% objective, but it represents substantial progress towards that goal.

All the Fed needs to do now is hike rates one more time, probably this month, and wait for inflation to fall to the Fed’s target rate. If a modest recession and rising unemployment are the cost of this triumph, Fed Chair Jay Powell is willing to pay it.

If this two-year inflation-deflation story appears overly nice and tidy, it is.

The usual economic models and straightforward explanations fail in several instances. Indeed, the split is so broad that it raises the issue of whether the Fed and orthodox economists know what they’re doing.

The best proof is that they don’t.

The Phillips Curve Is Unreliable Science

To begin, the Phillips curve predicts that lowering inflation should have resulted in increased unemployment. That has not occurred. The unemployment rate jumped to 3.7% in May, up from 3.4% the previous month, although it remains at levels not seen since the 1960s.

The March unemployment rate was 3.5%, whereas the February figure was 3.6%. Even after 16 months of monetary tightening, the unemployment rate has not increased significantly.

The 1930s had both high unemployment and low inflation. The 1960s were characterised by low unemployment and inflation. The late 1970s were characterised by rising unemployment and inflation.

There is no association between unemployment and inflation, according to history and data.

We must explore elsewhere for explanatory elements with true predictive significance. Similarly, despite Fed tightening, no recession has been seen in the statistics. It has been 38 months since the last recession ended. During that time, yearly growth averaged 5.88%.

The first quarter of 2023 had 1.3% growth. According to the Federal Reserve Bank of Atlanta’s GDPNow prediction, growth will be 2.1% in the second quarter of 2023. These latest growth rates are modest, but they do not indicate a recession.

There are several recession warning indicators, including inverted yield curves, and I anticipate a recession shortly. But it hasn’t arrived yet.

If unemployment remains low, the economy grows, and stock indexes remain in a bubble despite the Fed’s record monetary tightening, the Fed’s models and the mainstream Neo-Keynesian consensus are called into doubt.

What exactly is going on?

The incapacity of analysts to discern between inflation that arises from the supply side and inflation that develops from the demand side is the primary problem with model-based forecasts. When it comes to making predictions, making this distinction is essential.

The Psychology of Purchase Decisions

Inflation was genuine in 2021-2023, but it was driven by supply chain bottlenecks and shortages of vital products and industrial inputs. The supply chain interruptions were worsened by unprecedented economic and financial sanctions imposed as a result of Ukraine’s civil war.

This type of supply-side inflation is self-defeating. High prices diminish demand, which tends to drive down prices. This is evident every day, beginning at the petrol pump, where the record high prices in the summer of 2022 have dropped dramatically (but still higher than in 2021).

We see further evidence in OPEC’s decision to reduce oil supply in order to keep prices stable. In summary, inflation was genuine, but it’s already waning for reasons unrelated to the Fed.

The second fault in the models is a failure to comprehend the mechanism by which inflation might transfer from the supply side to the demand side if it persists for a long enough period of time. This is a shift in consumer psychology that manifests itself in behavioural responses. Standard models do not account for either psychology or behaviour.

If inflationary psychology takes hold among the broader population, it has the potential to feed on itself despite recession and falling actual earnings. The models do not demonstrate this, but history does. This is precisely what occurred in the 1970s.

The threat of inflation might be formidable

The Arab oil embargo of 1973, following the Yom Kippur War, triggered inflation from the supply side. From 1973 to 1975, the United States had a severe recession, with a peak unemployment rate of 9.0%. The United States had another recession in 1980, followed by a third in 1981-1982, when unemployment reached 10.8%. That previous recession was the most severe since the Great Depression.

Despite three recessions in nine years, double-digit unemployment, and two stock market collapses, the mid-to-late 1970s and early 1980s had the greatest inflation since WWII’s conclusion. In 1981, inflation had reached 15%, and interest rates had been hiked to 20% to tackle it.

This combination of poor growth and high inflation was dubbed “stagflation.” Inflation had spread from the supply side to the demand side by 1977, and it was out of control. Recessions couldn’t put a stop to it.

Even during times of economic duress, consumers respond to inflation in predictable ways. They expedite purchasing because they anticipate future price increases. They utilise debt to purchase physical assets and equities as safe havens against inflation.

Retailers hike prices to cover rising wage expenses while maintaining profit margins. The entire process is self-sustaining. And, like in 1975 and 1981, self-help may persist even during a recession.

Stagflation has already arisen in the United Kingdom. In the United Kingdom, CPI inflation is 8.7%. At the same time, the United Kingdom is on the verge of a recession, with 0.1% growth in Q4 22 and Q1 23, and anticipated growth becomes negative after that. Stagflation is not an exception in history. It’s a current reality.

Are we there yet? Is it feasible that we live in a society where human nature demands inflationary defence strategies that feed on themselves, notwithstanding the possibility of a recession and monetary tightening?

Some evidence of this may be seen in a new five-year deal for unionised teachers in New York City, which includes back pay and signing bonuses as well as a 20% wage increase.

There is no need to argue about whether or not teachers deserve this rise. The simple reality is that they have it. There are plenty such instances. How long until pay hikes for teachers and others are turned into greater consumer demand and higher retail prices, inflating the wage gains away? The economy might celebrate as if it were 1979.

To combat the tug-of-war between inflation and deflation, employ the Barbell Strategy

The likelihood of a recession and a stock market fall is strong. Nonetheless, the chances of continuing inflation and rising interest rates are significant. Despite what the traditional theories claim, these two occurrences are not incompatible.

We’ve seen them previously, in the late 1970s and in previous episodes.

We may be seeing greater inflation and interest rates for a longer period of time than Wall Street and the Fed anticipated. Given the uncertainty of the inflation/deflation battle, a diversified barbell strategy that protects against both is the best option for investors.

A model portfolio may include gold, natural resources, and energy equities as inflation hedges, Treasury notes as deflation hedges, and a solid allocation to cash between the two ends of the barbell to give liquidity and flexibility when market conditions improve.

As economists and analysts continue to be perplexed by the duality between inflation and deflation, it becomes evident that standard models are failing to provide reliable predictions. The historical link between unemployment and inflation is no longer valid, raising concerns about the efficacy of conventional economic theories. Furthermore, the influence of consumer psychology and behavioural responses on inflation dynamics is frequently neglected in these models. Rickards says that in this uncertain environment, a barbell strategy that includes investments in both inflation and deflation hedges can provide a balanced approach for investors looking to protect their portfolios. Investors may negotiate the tug of war between inflation and deflation by diversifying into gold, natural resources, energy shares, Treasury notes, and cash. This ensures flexibility and resilience in shifting market situations. As the inflation-deflation war continues, investors in this complex economic landscape must adopt a sensible and diversified investing strategy.

Rickards’ piece was featured on the Daily Reckoning.

 

 

Gold price (XAU-GBP)
1,859.28 GBP/oz
  
- GBP29.87
Silver price (XAG-GBP)
22.63 GBP/oz
  
- GBP0.41

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