Here Comes Inflation or Deflation?

It is an interesting question, are we heading for inflation or deflation?   What does that mean for interest rates and your investments in general?  What about prices?

Inflation or Deflation, No One Knows For Sure

Let’s start with a disclaimer.  Inflation and interest rates changes are never a sure thing. Expectation of inflation is a major player in interest rate setting.   That expectation of inflation changes over time based on how the public feels about prices going forward.  That sentiment is not something you can fully predict.

Defining Interest Rates

In fact the equation used in economics to describe interest rates is Nominal interest rate= estimated real interest rate + expected inflation.  Nominal interest rates in this case are what you actually receive on investment instruments.    Real interest rates meanwhile are the actual change in the purchasing power of the money invested.  In other words inherently what you receive in interest is a function of expectations of inflation and actual change in value.  This is known as the Fisher Effect.

The greater peoples expectations of inflation the higher interest demanded from actual investment instruments or the lower the actual increase in purchasing value.  One part of the equation has to give.  So what’s happening now?

Interest Rates are Currently Falling

Well interest rates are falling, in fact there is renewed expectation that interest rates in the US are about to go negative.  So we know that nominal interest rats are falling.  Falling nominal rates are consistent with what usually happens in a recession.   Demand for loans decreases either because people are hesitant to spend money or banks are hesitant to loan money.  We know banks are tightening lending standards currently, so we can validate this is happening today.

The Stagflation Exception

A minor digression here,  there has been one notable exception to deflation’s during a recession in US history.  A period in the 70s known as stagflation.  In this period interest rates rose during the recession where unemployment and declining demand occurred.  At least currently we are not experiencing stagflation.

Inflation or Deflation, an Aggregate Question  

So we know currently that nominal interest rates are falling.  This means either the real return of interest is falling or the inflation expectations are declining or both.  A note inflation expectations are an aggregate question, so it doesn’t matter what I believe or you believe.  It matters what society believes will happen with inflation going forward.  

It Seems Currently People on Average Believe in Deflation

I will tell you what I believe about inflation expectations in our current environment.    At the moment I believe it is a little bit of both real interest rate decline and people expecting  deflation.  Our leaders have told us to expect deflation for a long time.  I doubt the public has forgotten that overnight.  So what is going on currently?  

Consumer Goods are Experiencing Price Declines

With the exception of food most items out there in the market are decreasing in price.  Not a day goes by that I don’t see advertisements for sales of entertainment goods by major retailers.  They are attempting to offload their inventory before people finish spending their stimulus and the buyers dry up.  After that they will have more supply and then demand and thus they expect deflation*.  

*Stated otherwise they expect prices to decline.

Energy is Deflating

Energy is also experiencing a massive decline.  There is essentially a glut of supply and massively decreased demand.  The situation was so bad that contracts for oil in April went negative, as the cost to store the oil exceeded the potential profit to holding it.    In other word’s prices of energy have deflated.

The two exceptions I see are:

Food Is Inflating

The price of certain food has increased as supply shocks have been felt around the world.  This is especially true in the meat industry which has been heavily impacted by Covid-19. Individually packaged items are also experiencing some price increases, as the change in channel from resturant to home has changed packaging requirements faster then the supply chain can respond.    

It is however important to note these food supply chain impact appears to be a short term issue currently.  After the packaging begins to be produced and the virus stops passing through the meat workers one can reasonably expect the food supply chain to recover.  At least that’s what the experts in such areas are saying.

Real Estate is Inflating

Currently the price of real estate appears to be remaining constant.   I will point out that real estate tends to lag the rest of the economy by a few months.  Simply put it takes a few months for foreclosures and other adverse actions to begin to occur when people can no longer afford their mortgage.  When that happens the rest of the market begins to decline with it.  So again this appears to be a short term condition.  I am actually preparing to take financial advantage of real estate opportunities in the coming months.

We are Currently Experiencing Deflation

So at least in the near term I believe you can argue we are in a deflation environment and businesses are expecting continued deflation. At very worst you can argue we are the inflating at the same rate we were pre-crisis.

But Will We Continue with Inflation or Deflation?  

The mid to long term situation however is another question.   Money is simply a measurement of value.    That value in the economy is determined by what we produce.  We measure that as either what we consume or what we manufacture. But in essence the value of money relates to what we produce.

The Money Supply and Inflation or Deflation?

Right now however we are producing way less then normal.    So much of our manufacturing is sidelined.  Simultaneous the government has dumped huge amounts of money into the economy.  Theoretically the more money in the economy versus things of value the lower the value of money.    Inflation by any other name.

The Velocity of Money and Inflation or Deflation?

Those that remember 2008 are now asking, but then why did QE whatever not result in inflation?  Well, the amount of money is only one part of the equation.  You see money also has something called velocity.  Velocity of money is a concept of measuring how money moves around the economy.   

 If you pumped money into the economy and it just say in a bank account then conceptually that money is nothing more then a marker in an account.  The bank can offset this of course by lending the money out, but if there is no lending of consuming going on then in effect the money has no impact on inflation

2008, Bank Reserves, and Deflation.

It is arguable that we were able to pump money into the economy after the 2008 recession without inflation because the funds never left the banks.  The banks had increased requirements for keeping funds on hand to avoid running out of money.  As such they left the money on the books as a reserve, not lending it out.   Therefore velocity actually decreased through the recession. That offset the inflationary impact of dumping money into the economy.

2020, A Different Situation

But in 2020 banks already have those reserves on the books.  So the money dumped into the economy is not staying in the banks due to reserves.  It appears to me that instead the funds are flowing to large comany’s at the moment.  The stock market is quickly recovering from a low to a high price per earnings.   Also there appears to be significant inflows into the junk bond sector.   * Many of these company’s are issuing additional shares or additional bonds. Those actions are pushing the funds into these company coffers.

*It’s important to note that the price of company stock doesn’t relate to inflows to a company.  That is a transaction between individuals.  Only the issue of new stock or bonds sends money to company’s.

Where Does the Money Go Next? Inflation or Deflation?

In some cases this may be driving payoff of previous business debts and zombie companies, where the funds are propping up organizations we may be better off without.   So the real question of inflation or deflation going forward is where this money goes next.    Does it pass then to the banks through debt payoff where the banks sit on the funds due to tightening lending standards?  Or does it flow back into spending despite the overall decrease in demand.

I Personally Believe We are Headed Towards Inflation

I sit in the camp that inflation is coming.  The funds will eventually flow into the overall economy since there is no long term driver like additional reserves to suck up the extra funds.  There also doesn’t appear to be appetite for the Federal Reserve to increase their interest rates and thus suck excess funds out of the market at a later point.    Each time we’ve discussed an interest rate increase over the last few years the Fed has backed off due to fear of hurting the economy.  I suspect this will continue to our long term inflation detriment.

When Will We Pass From Deflation to Inflation, I Have No Idea

But the devil is in the details.  When do we pass from short term to long term?  When do we go from deflation to inflation?  Honestly, I don’t know.  I’m not Nostradamus. It could be weeks, months, or even a few years. What we set in motion today may not be fully experienced for a while.

There are too many moving pieces in this current  situation, and too many unique aspects like negative interest rates and being the world’s reserve currency, for anyone to give you a well founded prediction.  Let alone me who is just some guy with an Economics minor/MBA Finance and a hobby blog.  I just hope I get to buy real estate at a discount before it comes.

Do you believe we are heading for inflation or deflation?

For those with strong beliefs, these posts can give you some ideas on how to protect your portfolio from inflation:

General Ideas For Inflation Mitigation in a Portfolio

Inflation Protected Bonds In Particular