Unprecedented fiscal stimulus. Extraordinary money creation. Historically low interest rates. Troubling meat shortages. Prices only have one way to go: Up! Right? Wrong.
Watch out for deflation.
Fiscal stimulus increases the quantity of goods and services demanded; money printing devalues the dollar; low interest rates lead to overheating economies; and shortages reduce the quantity supplied while the quantity demanded remains unchanged. All of these factors are inflationary, so why should we be worried about deflation?
Let’s first discuss why deflation is bad, and then examine why it’s of paramount concern at the moment. I personally love seeing lower prices on the goods and services I consume. I liken it to a pay raise; but deflation is a very sinister economic phenomenon. If consumers expect their purchasing power to increase with nothing more than the passage of time, they’ll delay consumption. Multiply this decision by millions of Americans and suddenly company sales and profits get squeezed, leading to reduced investment and hiring. Weaker job prospects and stalled wages in turn lead to further tightening of the purse strings and a deflationary recession ensues.
It can get ugly. Deflation figured prominently in the Great Depression and, more recently, in Japan’s lost decades. It’s very difficult to fight, too. Japan’s experience has taught us that monetary policy, via money printing and negative interest rates, alone were insufficient to reverse the deflationary mindset that had infiltrated the Japanese population.
This brings us to present-day America. Our central bank, the Federal Reserve, acted quickly and aggressively in response to coronavirus-related shutdowns. But as we know, central banks can’t do it alone. Congress has responded with great force too. As this note went to print, Congress had already authorized $3.6 trillion in emergency spending. As a percentage of GDP, this is roughly equivalent to what Congress spent on recession-fighting measures in the five years during and after the financial crisis of 2008-2009.
Never mind if all this is enough to keep the economy afloat until it reopens—is it even enough to fight the deflationary pressures lurking in the shadows? A widely used gauge of future inflation expectations, derived from the trading levels of certain U.S. Treasury securities, is something called the “breakeven inflation rate.” What it tells us is that inflation expectations have fallen significantly. The chart below shows what the inflation rate is expected to average over the next five years.
Notice the sharp downturn in inflation expectations corresponding with government-imposed lockdowns in March of this year. The current reading is 0.70%. For comparison, it had barely dipped below 1.50% in the preceding three years. This represents a major shift in inflation expectations. Key decisionmakers at the Fed closely follow this inflation gauge as they formulate plans for more or less money printing. The Fed targets a 2% inflation rate. Thus, the current reading means: Print away!
It’s not a stretch to think that it also gives the greenlight to more fiscal stimulus. Not only is inflation of little concern, but government stimulus can be sold as a deflation fighting tactic, too. Barely has the first round of stimulus money been injected into the economy, and we’re already hearing pleas for more. All this paves the way for more government rescue packages, followed by high-fives and self-congratulation.
While it doesn’t feel entirely right saying this, the “good” news is that deflationary pressures give a free pass to monetary and fiscal policymakers to print and spend our way out of the crisis. The Fed has no self-imposed limits on its ability to create money, and Congress is highly unlikely to disappoint in an election year. In the fight for votes, who’s going to say “no” to putting more money in voters’ wallets? After all, “Work hard and pay taxes so that this great American experiment can be enjoyed by future generations in perpetuity” is not a very catchy campaign slogan. And all this can be done without the risk of spurring runaway inflation…in the near term at least.
Anthony Smith, CFA