Inflation or Deflation?
I read an interesting article in Money Mail a few days ago with the headline – “Will monetary ‘shock and awe’ send inflation soaring or are we set for deflation?” It is well worth reading. You can find it here:
Data shows inflation in the UK at least is tumbling. This is hardly a surprise with a severe global economic slowdown due to the Covid-19 pandemic along with a sharp fall in the price of oil. The cliff edge collapse in GDP, a key measure of economic activity and rise in unemployment is worse than during the Great Depression of the 1930s. Moreover with unprecedented monetary and fiscal support including the mass furloughing of workers the real economy so far, in the UK at least, has been largely shielded from the full force of the storm. Eventually the flow from the magic money tree will stop, (the UK furlough scheme is scheduled to finish at the end of October) and then the real pain will be felt. This will slow the economy and price inflation although it should be noted there is currently evidence of food prices increasing.
What we are witnessing is disinflation, which is a fall in the rate of inflation. So if inflation falls from 1% p.a. to 0.3% p.a. prices are still rising but not as fast as they were previously. Disinflation is not the same as deflation which is an outright fall in prices. Deflation is very rare. According to the Money Mail article the last time we had deflation in the UK was in April 2015 when prices fell by 0.1%. Prior to that you have to go back to the 1960s. The deflationary episode just over five years ago wasn’t anything to write home about but prolonged deflation is serious as the history of the Japanese economy shows after the bursting of the property and stock market bubble in 1990. With prices falling there is no incentive to spend if the consumer knows that the new car or TV they want will be cheaper tomorrow. Moreover in a deflationary environment the purchasing power of cash increases in real terms even if interest rates are zero whilst debt increases its real value relative to income and asset prices. It is a damaging negative spiral which is why the Japanese government and central bank have been so keen to generate inflation in the economy.
The fear of spiralling inflation is based on the unprecedented government and central bank support which has been faster and more extensive than during the global financial crisis of 2007 to 2009. Russ Mould, Investment Director at AJ Bell observed the current stimulus from the Fed dwarfs what it did 12 years ago. He wrote: “This time it has poured in $3 trillion in barely three months, whereas it added $3.2 trillion in QE stimulus in 12 years from 2008 to 2020.” To date the total stimulus around the world has been $20 trillion so far. The Bank of England announced a further £100 billion a few days ago. Back in 2008 it was mainly monetary policy to support the economy – ultra low interest rates and money printing. Fiscal stimulus – government spending and tax cuts was largely absent. However this time around government support has been massive. Alasdair McKinnon manager of the Scottish Investment Trust likens it to helicopter money, the government paying money direct into people’s bank accounts. This adds up to a much greater potential for inflation than after the banking crisis. However extended lock downs and social distancing will help kerb price inflation. Even if restrictions are eased a cautious public will be reluctant to go back to crowded pubs, restaurants, sports venues and shops and many will tighten the purse strings for fear of losing their jobs. Imported inflation is another story. That will depend on the strength of the pound and the extent of the UK’s reliance on imports. What we may see however is asset inflation as a consequence of QE and other monetary stimulus as we did after the financial crisis.
We simply don’t know whether we are heading for inflation or deflation but artificial factors are in play when it comes to the headline figures. For example the recent collapse in the price of oil will eventually fall out of the year on year inflation indices and wage inflation will spike as the unemployment rate falls. The government is so worried by this technical wage inflation increase that they are considering scrapping the triple lock on state pension increases*. My feeling is that we will see low inflation for the rest of the year but not outright deflation, unless there is a another economic shock. Longer term the global economic recovery could be slow and anaemic i.e. something similar to the post global financial crisis period. The global economy is still hooked on easy money. Remember the panic markets got into with the threat of withdrawal of QE – the so called “taper tantrum” of 2013 and quantitative tightening at the end of 2018. I am more inclined to think deflation is more likely than rampant inflation. Disinflation is OK provided it doesn’t tip into deflation. The Goldilocks scenario is modest inflation of say 2% p.a. The consequences of spiralling inflation or deflation on asset prices and investments is a subject in its own right. Something for another time. The Money Mail article reviews the case for gold but space does not permit me to comment on this here.
*The triple lock is a pledge to increase state pension each year by the higher of wage inflation, price inflation or 2.5%. If wage inflation artificially soars by 18% in 2021 due to a recovery in the economy state pensions increases of 18% would massively dent public finances. You can read more here:
The content of this blog are my own views based on the news articles quoted. It is intended as general investment information only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.