Inflation or Deflation? by Les Nemethy, former World Banker. CEO, Euro-Phoenix Financial Advisors Ltd.

Whether we live in inflationary or deflationary world has a massive impact for everyone:
  • For savers, retirees or anyone planning retirement, inflation may greatly diminish any income stream not indexed to inflation.
  • Investors in long-term bonds will see significant bond appreciation under a deflationary scenario, but lose much of their investment in an inflationary scenario.
  • Borrowers in an inflationary environment may repay in inflated currency, meaning they generate a windfall from lenders
So ‘inflation or deflation’ in the coming years is one of the great financial questions of our time. And there is far from agreement among economists. Economists seldom agree on anything…but here there are such strong forces at play—in both directions.

This article examines (a) some of the main inflationary and deflationary forces at play; (b) how these forces may play out over the coming years; and (c) ventures an opinion as to which is likelier to prevail over a 3-5 year time horizon.

(a) Some inflationary and deflationary forces at play

First, on the deflationary side:
  • a, over the past decades, there has been a huge deflationary benefit from outsourcing and globalization. Bringing hundreds of millions of mostly Asian inexpensive workers into the global workforce has created a windfall for North American and European consumers. China became the factory of the world, and flooded the world with cheap products.
  • b, Record levels of global indebtedness (currently around 330% of global GDP) also constitutes a deflationary force. People and companies have less disposable income when they are in debt.
  • c, Covid-19 lockdowns have created a demand shock. Even without lockdowns, covid creates a propensity to save.
  • d, An expected increase in defaults and bankruptcies further reduce demand.
  • e, Energy prices have moderated over the past decade.
  • f, Demographics–an aging population diminishes spending.
  • g, Wealth concentration also diminishes spending.
  • h, Technology allows for greater efficiencies and cost reductions.
On the inflationary side:
  • a, There have been massive increases in money supply, which has already helped fuel an asset bubble
  • b, Fiscal stimulus (‘helicopter money’) augments spending and inflation.
  • c, There have been supply shocks, stemming from a combination of factory closures due to covid. When demand comes back, supply in various sectors will have shrunk, creating inflationary pressures.
  • d, To manage political risks and possible trade disruptions, multinationals are diversifying their supply chains, bringing them closer to home (‘insourcing’). This comes at a cost, e.g. may have an inflationary effect.
  • e, Tax reductions, intended in part as covid relief, also contribute to inflation.
(b) how these forces may play out over the coming years

I classify the above trends into three categories:

(i) Trends towards future deflation. There is not that much more room for tax reductions—in fact, there may be a need for tax increases, at least post-covid, to cover deficit spending. The Biden regime is likely to increase taxes on the rich. This is deflationary; aging population and technology savings will also remain deflationary.

(ii) Trends difficult to forecast. It is uncertain whether wealth concentration can be reversed. It is also difficult to forecast whether energy prices will continue to diminish. We could for example see increases in oil and gas prices, at least over short periods.

(iii) Trends towards future inflation. The expansion of money supply has rapidly accelerated during covid, while fiscal stimulus and deficit spending have expanded exponentially over the past year. This has not yet translated into inflation, because velocity of money (e.g. the rate at which people spend) has collapsed. By approximately Q3 2021, we are likely to see a dramatic reduction in the covid infection rates, thanks to vaccines, which could increase spending and consumer confidence— which may speed up velocity, and in conjunction with unprecedented levels of fiscal and monetary stimulus hence trigger inflation.

(c) Inflation or deflation over the coming 3-5 years?

If I were a betting man, I would bet on the resumption and strengthening of inflation.

So why hasn’t there been inflation, despite massive money printing since the Lehman crisis? Most of the increased money supply found its way onto bank balance sheets, without stimulating an increase in consumer or corporate lending. Hence the increased money supply was “sterilized” within the banks. 2021 is likely to be different: the monetary stimulus is several order of magnitudes larger, accompanied by enormous fiscal stimulus (helicopter money) which goes directly into the hands of businesses and consumers.

While there are still strong deflationary forces at play, in my view, what will tip the balance towards inflation is the stated policy of central banks to do ‘whatever it takes’ to float the economy. Central banks see deflation as a larger threat than inflation. We already have asset inflation. Be prepared for consumer price inflation.

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