On Inflation vs. Deflation

On a recent Macro Voices podcast, Brent Johnson called the inflation vs. deflation conversation, “The debate of our time”, and John Authers of Bloomberg recently wrote, “People who argue that this inflation is transient and those who think it’s a secular trend both still have plenty of evidence. The debate remains open.”

Given we just wrote our Mid-Summer Inflation update, we figured it was time to put together another Editorial that brings together how some of the smartest guys out there are thinking about the various sides of this debate.

Our intent is to simply clarify where the views from the experts diverge and to understand how they came to their conclusions.

Let’s first set the stage with two important charts:

Percent change is the chart that tends to get a disproportionate number of headlines, but absolute price levels matter just as much (some would argue more), as it strips out base effects and generally illustrates the rise in inflation over time, as opposed to headline year on year growth.

We urge you to look at both in tandem to get a more complete view of the narrative.

Both sides of this debate are led by shockingly smart people.

Camp Deflation: Hoisington Investment Management

This section heavily leans on Hoisington’s Q2 Quarterly Outlook and Review. In it, they go much deeper on the concepts discussed below, and therefore we recommend you have a look for yourself (always trust but verify, even when reading the good-natured folks at Lykeion).

Dr. Lacy Hunt (EVP at Hoisington), one of the most prominent and well-respected deflationists out there, believes that after a few inflationary bumps ahead, we’ll likely be back to the disinflationary environment we’ve been in for the past 50 years.

Before moving on, let’s clear up a common misconception about money:

• The Fed does not actually print money; they create reserves, called deposits, for commercial banks to lend against (that brrr meme needs to die before it kills Jeff Snider).
• New money is created when commercial banks make loans to households and corporations. The Fed can pump up the balance sheets of commercial banks with as many deposits as they want, but that’s not new money (you can read about the effects these deposits are having on the Reverse Repo market here).
• So, if banks don’t lend against those deposits, no new money is created. Just because the Fed’s balance sheet is going up, it does NOT mean new money is being created. That’s only an expression of the potential for new money.

The Loan-to-Deposit ratio (chart below), which simply measures the number of loans made to the private sector vs. deposits on commercial banks’ balance sheets, is at an almost all-time low – i.e. banks are not lending because risk premiums (explained below) to lend to private sector borrowers are too high.

This broadly means that the risk-reward tradeoff is simply not enticing enough for banks to lend.

Economics 101 tells us that % Change in Gross Domestic Product = Velocity x Money.

This means that the growth of an economy can be expressed by the amount of money in circulation, and how quickly that money moves between the hands of users of that money.