You don’t hear a lot of people talking about deflation these days unless they’re scorning it. Inflation is all the rage in most circles and admittedly I’ve gotten caught up in the craze to some extent. However, I’ve been searching for contrary views on the inflation versus deflation debate as I wonder whether we really understand how inflation works and ultimately manifests itself. I use a collective “we” here referring to finance and economics professionals, academics, and pundits.
The market is clearly expecting inflation to ramp up. Five-year breakeven rates are at 2.50% while 10-year breakeven rates are at 2.28%. Interestingly, current inflation expectations aren’t much higher than we were actually experiencing prior to the pandemic. In other words, it appears the market is expecting inflation to get back up to, or slightly exceed, the pre-pandemic trend within five years only to drop off slightly over the subsequent five years. Is that really the significant pick-up in inflation many of us are anticipating?
5-year inflation expectations are right around what we were experiencing prior to the pandemic
10-year inflation expectations are lower than 5-year expectations
Prior to the pandemic, the Consumer Price Index for all items was growing n 2-2.5% YoY
I’m becoming increasingly surprised at how certain and convinced so many people are that above trend inflation is coming. I probably shouldn’t be, but I am. I believe I understand the logic behind the argument for higher inflation, but I still question how anybody believes they can know with any certainty what’s going to happen with something as complex and intertwined with the monetary system as inflation. I come back to what I said before. I question whether we have the necessary fundamental understanding of inflation to make bold predictions about its direction and the magnitude of any moves in that direction.
Quantitative Easing ≠ Higher Inflation
During and after the Great Financial Crisis, the Federal Reserve began its quantitative easing efforts which led many to believe rampant inflation was to come. The arguments made sense to me at the time and I thought meaningfully higher inflation was a distinct possibility. Inflation as measured by the CPI for all items peaked at just under 4% in 2011 and proceeded to decline to 0% in 2015 before climbing back up to 3% and settling into a 2 to 2.5% range. Clearly, our understanding of the Fed’s quantitative easing and its impact on inflation was incomplete at best. The Fed’s actions since the Great Financial Crisis have been extraordinary relative to the experience of the previous three or four decades. I’m not faulting anybody for not understanding how these extraordinary measures reverberated throughout the monetary system. However, avoiding overconfidence and not overlooking or dismissing the complexity of the Fed’s measures, the monetary system in general and inflation is pretty important.
The Rise of Inflation?
I’m assuming we will see some fairly large CPI prints as we anniversary last year’s lows. Whether those increases are sustained or not remains to be seen. There is a chorus calling for sustainably higher inflation again, claiming this time is different because of the massive amounts of fiscal stimulus that are being doled out. Again, the argument is very compelling and a lot of smart people are on board. Maybe we will get sustainably higher inflation this time. However, l think revisiting the basic fundamentals of inflation can provide some important longer-term insight.
Historically, an increase in the velocity of money needed to occur for inflation to pick up. According to the St. Louis Fed, the velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. As you can see in the chart below, the velocity of money has been in a down trend for 20-plus years and fell off a cliff last year when the pandemic struck and hasn’t really recovered any lost ground.
For inflation to sustainably rise then, money velocity needs to increase. For money velocity to increase, monetary transactions need to increase in frequency. Increased bank lending would help increase the frequency of monetary transactions through the multiplier effect, providing a shot of adrenaline in the arm of money velocity. In hindsight, it makes sense there wasn’t inflation after the Fed started quantitative easing after the Great Financial Crisis. Businesses, including banks, and consumers were shellshocked. Banks weren’t lending and other businesses and consumers were paying down debt and building up reserves out of fear of experiencing the pain of the financial crisis again, a classic example of the snakebite effect.
Fast forward to today. Supposedly there is an extremely high level of pent-up demand and high levels of personal income resulting from people being on lockdown and not having spent money. I’m pretty sure this is the case in most parts of the country. It seems very likely that we will experience a jolt in spending and in the frequency of monetary transactions. However, will it be a sustainable jolt or simply a one-time jolt in response to the country and economy “reopening”? If it’s not sustainable then it likely isn’t going to lead to sustainably higher inflation. Furthermore, bank loan growth fell off a cliff and is currently nonexistent.
Milton Friedman famously said, “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” There’s also a psychological element to inflation that can lead to consumers spending money more frequently if they believe the price is going to increase in the near future. I don’t believe we’re at that psychological point currently. I’m not suggesting sustainably higher inflation isn’t in the cards. What I am suggesting is we need to see more frequent spending (less saving), more lending (less deleveraging) and more economic activity overall before the long awaited sustainable rise in inflation occurs. Referring again to psychology, I’m not sure how close we are as a nation collectively to a state of persistent spending and borrowing again, especially with the mental and emotional scars of 2008-2009 and now 2020 still relatively fresh for a lot of people.