A recent piece of research from Casey’s got our engines going on the whole inflation/deflation debate. It’s been quite a while since I revisited the topic so let’s have a look at the evidence. Let me begin by saying that after having been a deflationista for several years I have substantially pared back my deflationist position to a more neutral position. I no longer have skin in the game per my market bets so consider me an innocent bystander. While I still believe there is much de-leveraging to be done we have likely thwarted the deflationary spiral that I feared was developing in late 2008. Nonetheless, inflation remains a minor concern in the United States for several reasons. Let’s take an in-depth look.
The tendency is to argue that more money = inflation. After all, the great Milton Friedman said that inflation is always and everywhere a monetary phenomenon so it must be true, right? Not so fast. Friedman lived in a different time. A time when the velocity of money was stable and the gold standard was still a viable idea.
Let’s start with the various types of inflation – demand-pull inflation and cost-push inflation. As of now, demand-pull inflation appears unlikely. Recent data shows this is unlikely due to high levels of spare capacity, low capacity utilization rates and generally tepid demand for goods (aggregate demand is still very weak). Despite the oodles of excess money (mostly due to government spending) in the system there is nothing in the data that currently suggests this recovery will result in massive demand-pull inflation. In fact, the evidence as of now suggests a potential disinflationary environment.
The cost push inflation debate can be answered in one word – jobs. The majority of cost-push inflation is due to labor. As of now, labor remains near its lows and the unemployment rate is unlikely to tank any time soon. Anyone looking for a bout of wage inflation better own a leveraged portfolio of stocks because that would require a remarkable economic turnaround. There is no evidence as of now that the jobs picture is picking up substantially.
Some inflation proponents argue that we are about to begin importing inflation from abroad, but again the evidence suggests this is unlikely. The scenario generally goes something like this: the dollar will collapse and import prices will skyrocket. Most inflationistas learned this the hard way last year when they assumed that gold and other metals were the safest assets on the planet. Unfortunately for their portfolios, in a fiat world with a dollar reserve, that safehaven asset happens to be the dollar. Besides, a 10% decline in the dollar contributes approximately 0.5% to CPI according to recent research from CitiGroup. And if the dollar truly does collapse? You’d better own lead bullets, a bomb shelter and canned goods. Inflation will be the last of your worries.
Next up is the old “commodity prices drive inflation” debate. This is another falsehood. Did you know that a $20 increase in oil adds just 1% to annual CPI? Despite this, a rise in commodity prices without a subsequent rise in wages is essentially offsetting in terms of future inflation. We learned this in the Summer of 2008 when oil and gas prices shot up to their all-time highs and wages remained stagnant. At the time, I was calling for a massive deflationary decline because the two simply didn’t add up. Without a rise in wages you simply can’t support the high commodity prices. Free markets working at their best. This goes back to the cost push debate. If commodity prices are going to continue to climb substantially we are going to need to see substantial wage inflation. It’s not happening as of now.
The Fed actions take us into the real heart of the debate. Investors are infatuated with the explosion in the money supply. This horrifying image:
What this chart doesn’t show is the decline in real credit. This explosion in the money supply does not mean it is actually getting into the system (in fact, reserves don’t ever “get into the system”). I will simplify this with my iced tea example. Imagine you have a full pitcher of water (the economy). If you place in a scoop of iced tea mix (new freshly printed money) it will sink to the bottom. But you don’t have iced tea yet. You have to mix it in. Inflation works in a similar fashion. When the Fed prints money the banks need to actually lend the money for it to get into the system, but an extension of the monetary base does not necessarily equal an increase in lending. That’s just not how bank lending works. Without the mixing (lending) you don’t get iced tea (inflation). As of now, the lending markets remain very weak.
All of this adds up to one thing. Demand for credit is weak and the supply for credit is weak. That means an expansion in the broad money supply is highly unlikely at this time. In other words, we’re not getting any iced tea and that’s why inflation readings continue to come in well below what the inflationistas are betting on. I would describe the current environment as disinflationary with a greater risk of deflation than hyperinflation.
Of course, this is not to imply that inflation doesn’t become a very real concern down the road, but as of now, there is almost no evidence that suggests inflation (or hyperinflation) is a real near-term concern.