Inflation Hype is Likely Overblown
Why Deflation May Be a Greater Threat to the US Economy
One of the top stories surrounding financial markets in 2021 has been the return of inflation. After a series of unprecedented actions taken by governments and central banks to keep households and businesses afloat during the pandemic, debate rages over how severe and prolonged inflation will last.
For their part, the numbers sound ominous. This year, the Consumer Price Index (CPI) has hit levels not seen since the financial crisis. The NASDAQ Composite Index lost 10.5% between February 12 and March 8 based on fears that higher inflation would make companies (and their future earnings) less valuable. In July, the Labor Department reported that the CPI rose 5.4% over the previous year and 0.5% over the prior month. That was the largest monthly increase since August of 2008. In August, the CPI rose another 0.3% from July, a 5.3% year-over-year increase.
Some critics have claimed the US economy is staring down the barrel of sustained high inflation, perhaps even hyperinflation, pointing to the staggering amount of money creation that has kept the economy and asset markets propped up during both the crises of 2007-08 and 2020. Defenders of Fed policy have largely countered with their belief that this will be temporary. Evaluating relevant data and historical parallels shows not only are they likely right, but that deflation may even be a greater danger lurking ahead.
What Does Hyperinflation Look Like?
There are multiple ways inflation can manifest. It can happen when supply and demand imbalances cause the prices of specific goods to quickly rise; it can also happen when a government or central bank devalues the existing stock of money by printing more. Economic growth naturally creates a modest level of inflation, and supply shocks like natural disasters or oil embargoes can create temporary bouts of high or extreme inflation, but one thing hyperinflation events have all had in common is their cause: currency creation.
Historically, hyperinflation has gone hand-in-hand with conflict. The first recorded hyperinflation was during the French Revolution, and 17 more happened throughout the 20th century. Almost all coincided with major wars or conflicts, including the World Wars, revolutions, military coups, and the collapse of nations. Looking back at some of history’s best-known examples, albeit from a very high level, doesn’t reveal much similarity with the present-day United States.
“One thing hyperinflation events have all had in common is their cause: currency creation.”
The Greek hyperinflation of the 1940’s occurred during the Nazi occupation, which Germany forced Greece to pay for. Since trade and industrial production were brought to a complete halt by the war, Greece couldn’t keep up with the cost and tried to print money starting in 1944 to continue paying its liabilities. This completely paralyzed the whole Greek economy until well after the country was liberated from Axis occupation and required a series of monetary reforms including the introduction of a new currency before finally stabilizing in 1947.
Weimar Germany in the 1920’s might be the best-known example of all. The Treaty of Versailles saddled Germany with an extremely punitive reparations debt to the victors of World War I, and Germany was forced to pay with gold or foreign currency. Having abandoned their gold standard in 1914 to finance their war effort through debt rather than taxes, Germany was forbidden from repaying with their devalued papiermark. Their post-war economy in shambles, Germany just printed more papiermarks to buy foreign currencies with, driving an epic hyperinflation which peaked at 29,500% per month. Of course, this also tragically helped propel Hitler and the Nazi Party to power.
The most recent hyperinflation happened in Zimbabwe in 2008, and it was one of the worst on record with a peak monthly inflation rate over 79 billion percent. In the early 1990’s, President Robert Mugabe seized all land from ethnically European farmers and gave it to ethnic Zimbabweans. Food production plummeted, which triggered extreme shortages and inflation. Hyperinflation officially began in 2006 when they printed 21 trillion Zimbabwean Dollars (ZWD) to pay off loans to the IMF. 60 trillion more ZWD were printed to pay government and public worker salaries. The government next declared inflation itself to be illegal, punishing businesses who raised their prices. In the end, what wound up providing the greatest stabilizing force was when they ran out of paper to print more money on.
Simply put, there is not an abundance of examples of historical hyperinflations that bear much of a resemblance to the present-day United States.
Understanding the CPI
Of course, just because the risk of hyperinflation appears very low does not mean there can’t still be substantial inflation. Whether one is worried about hyperinflation or not, this year’s elevated CPI figures are undeniable. What does this mean?
The CPI takes the weighted average of prices for 8 components: food & beverages, housing, apparel, transportation, medical care, recreation, education & communication, and other goods and services. Each component also has subcomponents, for example energy is a major subcomponent of both transportation and housing.
Y-O-Y Energy Change
M-O-M Energy Change
Looking at the CPI broken down by component paints a less troubling picture than the headline figure. The components show exactly why we have good reason to believe that 2021’s bout with inflation will be transitory, as has been argued by prominent figures like Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen.
Both the year-to-year and month-to-month data show the biggest contributors to the CPI’s rise are directly linked to the re-opening of the economy: increasing demand for energy, travel, and vehicles. The re-opening is a one-time event so we can expect its effects to wear off in time, plus these factors exist in a feedback loop that can produce an overstated headline number.
Figure 1: Year-over-year & Month-over-month CPI rates of change
For a simple example, think of used car prices. They plunged in the early days of the pandemic as cash-strapped businesses and households sold their vehicles for cash to cover their expenses. Selling into a market where prices are falling causes prices to fall even further since buyers are flush with options and sellers must take what they can get.
Now that demand is recovering, we see the opposite: used car prices are now higher than ever because those same actors are racing to rebuild their auto fleets and must outbid others who are doing the same. These rapid price movements contributed heavily to both deflating and inflating the CPI, however their impact would not have been noticed at all by those who did not buy, sell, or lease a new vehicle during this time.
Short Term Capacity Bottlenecks Are a Contributing Factor
The Capacity Utilization Rate is a helpful indicator to track how efficiently an economy is running. It measures total output as a percentage of potential output to express how much of a country’s production potential is in use. Capacity utilization is still not fully back to pre-pandemic levels, and even its current value of 75.38% is very low compared to other economic recoveries in prior decades.
Figure 2: Capacity Utilization Index
This means there is substantial untapped production capacity yet to be brought back online but likely would be if prices remain elevated. This happened the last time the US experienced sustained inflation in the 1970’s. Immediately after the inflationary shocks of 1973-74 and 1979, capacity utilization rose as firms increased their output to capture higher prices.
Capacity utilization mostly hovered between 80% and 90% in the 1970’s. This indicates the supply side was thriving, operating close to full capacity. Buyers were competing for more goods than were available, thus driving up prices. With so much productive capacity sitting idle today, the issue lies with shortages caused by supply chain issues.
Obviously, these capacity constraints will not last. As more states and localities ease pandemic-related restrictions, and as emergency unemployment subsidies end, the last holdouts will have to come back to work, and production levels can normalize. When this happens supply chain bottlenecks will ease up and prices can begin to stabilize.
Inflation Has Already Happened
If you were watching for a stunning growth in the money supply since 2009 to translate into a corresponding explosion in the CPI, surely you have been scratching your head. It didn’t happen. It defied traditional logic: how could so much money creation be accompanied by historically low inflation?
Figure 3: M1 Money stock vs. Consumer Price Index
The answer is that it wasn’t. The inflation just didn’t hit commodities or consumer goods. Since the Fed began quantitative easing in 2009, however, the run up in asset prices has been staggering.
Quantitative easing is when the central bank buys assets, usually bonds, from banks to stimulate the economy. The benefits are twofold: the large bond purchases lower interest rates which helps boost lending and economic activity. Secondly, it also provides support to asset prices during a period of uncertainty or crisis.
The reason QE has not been inflationary in the traditional monetary sense is because the new money it created did not go directly into the general economy. Rather, banks wound up holding on to large excess reserves of cash and ultra-low interest rates provided cheap leverage for investors to finance speculative investments and drive asset prices into the stratosphere.
When the central bank pushes interest rates toward zero, it nudges savers and investors into riskier assets to continue to earn their desired rate of return. For example, an investor who wants to earn 3% might no longer be able to find that in the bond market and choose to start investing in dividend stocks that yield 3%, with potential for capital appreciation.
Figure 4 shows the direct correlation between the rise in M1 money supply and the rise in the S&P 500 stock index. But stocks are not the only asset class that QE brought to record heights. Figures 5 and 6 show the correlation between the growth in the M2 money supply with the increase in real estate values and the 10-year Treasury Bond.
Figure 4: M1 Money stock vs. S&P 500 Index
Since its inception, the S&P 500 has averaged an annual return between 8-10%. According to S&P, over the last 10 years the index has returned over 15% per year, including blowout figures over 31% in 2019, 18% in 2020, and another 18% so far in 2021 as of this writing.
Home prices have also been red hot. Since 1975, the Case-Shiller Home Price Index has risen about 5% per year. Over the past 10 years, it has risen by 6% per year. However, 10 years ago the economy was still fresh off a mortgage crisis. More recently, the outsized growth is clearer: 7% annually the last 5 years, 8% annually the past 3 years, and 17% in the past year.
Figure 5: M2 Money stock vs. S&P/Case-Shiller Home Price Index
Because bond prices and yields move inversely, the 10 Year Treasury bond also reached an all-time high valuation by QE pushing yields to all-time lows. The 10-year yield was over 4% for most of the 2000’s before marching down to its nadir of 0.52% in August of 2020.
Figure 6: M2 Money Stock vs. 10-Year Treasury Yield
As economist Paul Krugman explained in his 1998 paper on liquidity traps, the closer the nominal interest rate gets to zero, the greater the indifference consumers and banks will have between holding cash and holding bonds. He concludes this would have no effect on the overall price level as banks would simply hold on to excess reserves. Figure 7 demonstrates this exactly. Between 2009 and 2020, the relationship between the Fed Funds Rate, the monetary base, and excess reserves held by banks behaves exactly as predicted by Krugman.
Figure 7: Effective Federal Funds Rate vs. Total Monetary Base & Excess Reserves Held by
The problem with quantitative easing is that it creates a dependency where asset values and continued growth become too reliant on the abundance of credit. What starts as a welcome support for capital markets during a time of crisis can quickly turn into an asset bubble.
When traditional asset classes are all outperforming their relative norms, market participants who are inclined to try and “beat the market” must rely on tools like leverage and/or increasingly risky and speculative investments to achieve their objective. Ultimately, credit will tighten either when the central bank stops QE or when banks lose their appetite for risk and cut back on lending. Either way, a credit contraction would trigger a deleveraging-driven recession.
The paramount risk then becomes the liquidity trap. A liquidity trap is when a central bank’s monetary policy loses all efficacy. The trap is set when a credit contraction leads people to hoard cash. Low rates create a prevailing assumption that they will soon have to go up, which would devalue existing bonds and keep investors disinterested. Since rates are already low, the bank also lacks the option to stimulate the economy with a rate cut. They are left with no monetary policy tools to fight the recession, which brings about deflation.
Deflation can be quite dangerous on a macroeconomic level because of its relationship with debt. When prices and asset values are rapidly falling, borrowers are hurt because the principal and interest on their debt remain fixed. When deleveraging occurs, defaulting on liabilities or selling assets into a down market can create a systemic shock where each wave of fire sales and defaults trigger another wave. Wealth is destroyed and credit availability contracts severely, even for sound borrowers. Without sufficient capacity to borrow and lend, economies stagnate or shrink.
Japan’s Lost Decades: A Lesson in Post-Bubble Deflation
In the decades following World War 2, Japan’s economy was one of the most prosperous on Earth. GDP growth averaged a blistering 6% per year between 1960 and 1990, and between 1980 and 1990 the market capitalization of all firms listed on the Tokyo Stock Exchange increased more than sevenfold.
It is also important to understand that Japan does not operate in a truly open, competitive free market economy like much of the Western world. Their economic structure is a cartel system known as keiretsu, which functions as a network of formal partnerships that dominate the economic landscape. The banking system in Japan is called a horizontal keiretsu, which is an alliance among banks who all cross-own shares of each other.
The late 1980’s demonstrates the fatal flaw of this model. During the bull market in equities, Japanese banks issued new equity and equity-related securities worth over 6 trillion Yen. However, this equity was being issued at higher and higher valuations and made each bank’s own financial stability increasingly dependent upon that of all the others. Risk was piling up and the foundation of their financial sector was quickly becoming a house of cards.
Like any classic financial bubble, the ride to the top was fueled by a massive amount of leverage. In Japan’s case, there was an abundance of cheap debt to finance risky or gimmicky activities through posting land as collateral. Property posted as collateral was said to have directly or indirectly supported as much as 80% of the total loans made by Japanese banks. Because of this and tax policies designed to punish banks for keeping reserves on hand to offset bad loans, by 1991 Japanese banks had reserves of just 3 trillion Yen against outstanding loans of 450 trillion Yen.
Eventually, the bubble burst in spectacular fashion. Between 1989 and August of 1992, equity values dropped 60% and land values dropped over 70% by 2001. What happened?
The bigger the bubble got, the more concerned the Bank of Japan had become about inflation. Between 1987 and 1989, the annualized money base growth went from 6% to 12%. To try and prevent inflation, the BOJ slowed base money growth to under 2% between 1991 and 1993. Rather than gently deflating, this burst the bubble. Private investment growth collapsed and took the banks, stock market, and real estate down with it. Japan fell into a liquidity trap.
Indeed, from 1995 to 2007, Japan saw its GDP shrink from $5.3 trillion to $4.3 trillion, real wages fell by 5%, and national debt as a percentage of GDP rose from just under 56% to over 150%. Flatlining worker productivity made it too hard for the economy to grow out of the trap and over a trillion dollars into public works spending largely did not have any stimulatory effect.
In the private sector, stimulus spending mostly went towards propping up failing businesses, creating a generation of zombie companies who should have been allowed to fail but instead perpetuated the misallocation of resources.
Inconsistent and ineffective policy responses ushered in multiple decades of fits and starts that the Japanese economy is still dealing with today.
Demographics Play a Role
One factor that may largely explain why the Japanese economy has not been able to escape the deflationary trap is age demographics. A popular theory has emerged positing that Japan’s economy has not been growing because Japan itself has not been growing.
Japan has long had the most rapidly aging population in the world. This has been due to a combination of declining birth rates, increasing life expectancies, and virtually no immigration. Japan’s working age population peaked in the early 90’s and begun a decline that is still ongoing. In a 2014 Working Paper for the IMF, Anderson, Botman, and Hunt summarize the prevailing research literature explaining Japan’s predicament.
Figure 8: Working Age Population (% of pop.) of United States (red) and Japan (green), 1970-2018
Economists Konishi and Ueda (2013) researched the ties between inflation and population aging in developed nations. Their analysis concluded that the effect of population aging can be either inflationary or deflationary depending on its root cause. When caused by increases in longevity, aging was found to be deflationary, and when caused by declining birth rates, aging was found to be inflationary. Additionally, Ikeda and Saito (2012) studied the effects of demographic changes on real interest rates and found declining labor force participation rates reduced real interest rates. A decline in the number of wage earners, and thus in the workforce, reduces the demand for loanable funds from both households and firms. This also spills into land prices. When retired workers downsize into smaller homes and businesses don’t have as many workers to accommodate, demand for land declines which further reduces demand for loanable funds. Finally, Katagiri (2012) studied the effects of aging on growth, unemployment, and inflation and concludes aging does have deflationary effects on an economy. Generally, aging leads to a shift in demand from durable goods to services which itself increases structural unemployment and reduces productivity and wage growth.
Returning to the IMF working paper, the authors also found dissaving by the elderly upon retirement to be a surprising contributor to deflationary effects. One might expect the elderly liquidating assets to spend on consumption and services to be inflationary. Because aging Japanese savers owned a relatively large amount of foreign assets, their repatriation caused an appreciation in the Yen. The deflationary impact of the currency appreciation more than offset the inflationary impact of higher consumer spending.
At a cursory glance, the concern over elevated inflation is understandable. The US has a very large national debt, there has been a massive amount of money creation in recent years, and the CPI is rising. However, the CPI increase is being driven mostly by the re-opening of industries who operate at extremely reduced capacities in 2020.
Unlike those countries who flooded their economies with freshly printed money to buy tangible goods, foreign currencies, or to reduce debt, the bulk of US money creation has been held in reserve by banks or invested in the capital markets. Not enough of the money created by quantitative easing has gone into the real economy to create persistent high levels of core inflation.
Through the lens of asset prices, substantial inflation has already occurred and presents a greater worry. Stocks, bonds, and real estate have delivered substantially higher returns than normal within the past decade while repeatedly reaching new all-time highs. It is also apparent that support for these values has been reliant on cheap leverage through monetary expansion.
Demographically, the United States in 2021 is in the early stages of rapid aging just as Japan was in the 1980’s and 90’s. Like in Japan, the birth rate and working age population have been falling. One key dissimilarity is the US’ regular influx of immigrants, which can support population growth even when the birth rate is falling and will be necessary to sustain the working population if the birth rate trend does not soon reverse.
Other key dissimilarities include stricter banking regulations that exist today which were designed to help protect the financial sector and broader economy from the contagion that precipitated so much devastation in the Japanese markets in the late 80’s. Likewise, far fewer Americans own substantial amounts of foreign assets, so continued aging in the US population should have more of a depreciative, and thus inflationary, impact on the Dollar than Japan saw its retirees have on the Yen.
In the best-case scenario, continued technological progress augmented with sustainable levels of immigration will help the US economy remain productive enough to continue facilitating growing prosperity well into the future. However, as it stands, the country appears perilously close to a point where one misstep with monetary, fiscal, or immigration policy could ignite a severe debt deflation and potentially wipe out trillions of dollars of wealth.
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