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Post-COVID Stimulus: Inflation or Deflation?

We can expect to see some level of inflationary bottlenecks, especially in heavy industries which are easily switched off but take time to switch back on.

Key Takeaways

  • We can expect to see some level of inflationary bottlenecks, especially in heavy industries which are easily switched off but take time to switch back on.

  • But in the short to medium term, the global economy is likely to see deflation.

  • Governments and central banks will do everything in their power, and then some more, to help the economy stay afloat, but the current backdrop is one of fragile debt, low levels of inflation and slower demographic growth.

  • As COVID leads to demand destruction and velocity of money continues to plummet, the fragility of the economic recovery of the last decade will show its true colors.

“The depth and magnitude of the economic drop-off [as a result of the coronavirus pandemic] took modern monetary theory—or the direct monetization of massive fiscal spending—from the theoretical to practice without any debate…We are witnessing the Great Monetary Inflation (GMI)—an unprecedented expansion of every form of money, unlike anything the developed world has ever seen.”

Paul Tudor Jones (hedge fund titan, founder of Tudor Investment Corp), May 2020

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Milton Friedman, The Counter-Revolution in Monetary Theory, 1970

The Inflation Debate: Two Tribes go to War

According to Investopedia, “Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over some period of time”. Or to put it another way, inflation is a sustained increase in the price of goods and services.

Inflation versus deflation has become a distinctly tribal debate. This only goes to confuse matters, because when people discuss inflation and deflation, they assume that they are mutually exclusive, whilst in reality inflation and deflation can occur simultaneously, in quick succession or in glorious isolation. They can both be broad-based or very specific.

Inflation or deflation is often an individual experience, shaped by personal circumstances. One person’s inflation, such as house prices, private education and private health care may be crippling, whilst of little impact to others.

Even the mention of the Consumer Price Index (CPI) can turn the inflation camp apoplectic with rage. To this group, CPI is accordingly “fraudulent”, because the basket of goods is constantly changing, with inflationary goods being removed by governments who are (allegedly) manipulating the data for their own sake. US CPI, however, has only fallen below zero (i.e. into deflation) once in the last fifty years.

The CPI haters, however, rarely provide a robust alternative for measuring inflation over an extended time frame (gold strength versus other currencies is often the preferred metric for demonstrating a loss of purchasing power).

CPI does have its flaws, but this is true of many economic data sets on which historical analysis depends. Despite these flaws, I will use CPI, mainly to highlight what happens to inflation at a particular moment in time.

The inflation and deflation debate is often portrayed in derogatory tones, such as “crippling inflation” or “debilitating deflation”. Various forms of inflation are always present: long-term phenomena like technological advancement should put downward pressure on inflation as our productive prowess improves, whilst population growth (at least, unexpected population growth) should put upward pressure on prices as it represents an unexpected increase in demand, to which supply will take time to adjust. Inflation is omnipresent; what changes across time, and ultimately what really matters, is its scale and speed and that is what economists usually focus on.

The extremes of the Weimar Republic’s hyperinflation post-WWI and the United States’ deflation of the Great Depression are now beyond most people’s living memory, only recalled in history books. The last great period of broad-based (global, rather than single country) inflation occurred during the 1970’s stagflation, which ended with the double-dip recession of the early 1980’s and the US Federal Reserve Chairman Paul Volker taking interest rates close to 20% in order to stamp out the inflationary fires that had been burning for much of the previous decade.

The specter of the seventies still haunts economists, whilst the collapse of societies from Germany’s Weimar Republic to modern day Venezuela forewarn us of what happens when money dies. Venezuela’s inflation hit 350,000% in 2019 after the economy lurched from being one of South America’s most prosperous countries to being one of its most destitute.

Most investors in developed economies satisfy themselves with “it couldn’t happen here”. But is that really the case? Could today’s maniacal money-printing, highlighted by Paul Tudor Jones, spawn a new era of inflation (or worse)? In order to get a handle on where we might be going, we first need to understand where we came from.

The Past: Monetary Expansion in a Fragile World 2008-2020

The last decade has already been an era of extraordinary monetary policy. Except that no-one thinks of it as extraordinary anymore. It’s become the new normal. Many investors have only experienced a regime where money printing kicks-in at the first sign of trouble, whilst central bankers are haunted by the specter of Lehman Brothers and a desire to do “whatever it takes” to prevent another crisis on that scale.

Immediately after the Great Financial Crash (GFC) in 2007-2008, central banks were justified in stabilizing the system and preventing the liquidity crisis from becoming an all-encompassing solvency crisis. This was a blueprint that had been two decades in the making, passed along the line from Greenspan in the late 1980s, initially via the monetary easing of interest rate cuts. When these failed to hit home, central banks started to increase their balance sheets in the hope that commercial banks would pass-on some of this cheap money into the real economy, and thus promoting liquidity to boost the economy and minimize insolvency cases. Welcome to the world of Quantitative Easing (QE).

By 2011, Europe’s economy was reeling. Facing the existential crisis of Eurozone debt (too much debt, but too few revenues), the European Central Bank (ECB) started to accelerate its own unorthodox accommodation which eventually led to a full-blown QE program a few years later.

In 2014-2015, the US teetered on the edge of a recession, which seduced central banks into keeping financial conditions easy. By extending the era of low interest rates (lower-for-longer), the consumer managed to keep ticking along because borrowing costs for any credit service (from credit cards to mortgages or auto loans) remained permissive.

Corporate earnings had stagnated, but the global economy just managed to keep its nose above water, not only due to the permissive interest rates environment but also because the People’s Bank of China re-opened its spigots in January 2016, launching a tsunami of new credit that helped rejuvenate demand. A month later in Shanghai, and after China had fired a mini-devaluation warning shot across the bows a couple of months before threatening to increase the value of the currency in the US, the G20 nations allegedly reached an accord to prevent the rapid rise of the US dollar (a rising dollar would have tightened global financial conditions, akin to the US raising interest rates). As a result, a deeper slowdown was again averted, but the fragility of the recovery was showing its true colors, and central banks had been warned about how hard it would be to let the economy run its course unassisted.

If, in 2008, you had asked most economists what they thought would be the end result of this money printing, they would have said “inflation”. They were partially right, though mainly wrong.

Goods and wage inflation remained benign, but asset prices such as the S&P500 index in the US soared, disconnecting from corporate and economic fundamentals. This is, fundamentally, one of the larger consequences of Quantitative Easing: asset price inflation which ends up benefitting the owners of capital.

Retrospectively, it seems that through this decade of Quantitative Easing (QE) we’ve spent a lot of money for little growth. Instead of enabling the global economy to recover its healthy growth path, QE barely managed to keep it from slipping into a deflationary coma. Median real income struggled to regain its pre-2008 levels and we saw that each new unit of debt in the balance sheet was bringing in less and less economic growth.

At the expense of a lot of debt and despite stagnated earnings, Asset price inflation continued, fueled by the suppression of volatility (economic and asset price) due to the actions of central banks, buybacks (much more in the Deep Dive) and the rise of rules-based funds such as risk-parity (like Ray Dalio’s Bridgewater hedge fund), which invest based on criteria such as volatility of different asset classes rather than valuation. Economic inflation, however, remained sluggish. Broad-based inflation (such as wages and economic growth) had failed to materialize despite the massive monetary stimulus.

And then came COVID.

The Present

Patterns of inflation and deflation will evolve based on the strength of balance sheets (i.e. the level of indebtedness) at the household, corporate and government level prior to the virus, the scale of the economic decline (drop in consumption) during the lockdown, the magnitude of the policy response (additional government expenditure) and how behavior responds to these factors (levels of future consumption).

The COVID crisis has seen one of the sharpest declines in economic history – the speed and depth are certainly without parallel.

From payrolls:

To a collapse in consumption:

The Bank of England expects the contraction in the United Kingdom will be the worst since the early 18th Century (we used to behead people with the guillotine then…). The speed of the economic contraction has been so fast that the policy response was unhesitating (the GFC was a slow-motion train crash by comparison).

The magnitude of this economic contraction is on such a scale, that we could see a V-shaped recovery in the economic data and still be well below the extremes of history.

However, switching the lights off is far easier than turning them back on. A V-shaped recovery assumes no change in consumer behavior. It assumes that the underlying economy was previously on a strong footing and it assumes that there has been no damage done to balance sheets at the household, corporate and government level. Even if the rebound is swift, in many cases the damage will be permanent.

With COVID sweeping across the world, major central banks are re-visiting the tried and tested 2008 policy toolbox, but this time on steroids.

The New, New Hope: Central Banks on Steroids = Inflation

Over the last decade, central banks cut rates to zero and printed record amounts of money, but still, inflation hovered near the lows. Despite that, their solution for the same problem of low inflation has been, so far, to do more, much more, significantly more… like really a lot more… of the same.

The Canadian and Australian printing presses have also swelled with the ranks of countries engaged in Quantitative Easing, along-side the US, Europe, Japan, China and others, bulking up the global monetary base at an astonishing rate.

Will COVID-19’s hollowing out of demand ensure that households choose to save instead of spend? Can we, therefore, see the monetary base expand at a record pace and still see deflationary forces at work?

The Future

A recession seems to be inevitable. How does CPI react during recessionary periods?

CPI has been remarkably stable over the last 30 years (even accounting for its ‘distortion’ by successive governments). After each and every recession of the past few decades, CPI has fallen in its immediate aftermath, though in most cases this wasn’t outright deflation (price decreases), but slower levels of price growth (disinflation).

Given our low starting point for CPI today, it seems fairly logical to assume that measures of inflation will turn negative in the coming months (i.e. into outright deflation). How persistent will it be?

Even prior to the COVID-crisis, price increases (CPI) were already trending at a historically subdued levels (disinflation). This is clear from the broad-based commodity market (commodities being a key component of many inflation calculations).

The Refinitiv Core Commodity Index has now unwound all the 2000-2008 China led commodity bubble (the index includes commodities such as crude oil, copper, and agriculture).

It is also a clear-cut trend in the U.S. bonds yields with U.S 10-year yields in a downtrend for forty years.

The fear of deflation was implicit in the monetary response of the world’s central bankers (lower interest rates initially, then QE eventually). Aggregate balance sheets were expanding for most of the last decade in the hope that aggressive monetary expansion would prevent global economies from entering the sort of deflationary spiral that crippled the US during the 1930s. This one overriding concern has been at the center of the last decade’s money printing frenzy.

A recession on top of a disinflationary backdrop should be deflationary. But there are more variables to take into account when talking inflation. Supply chain disruptions are having impacts in both directions and there are already some spectacular incidents of inflation.

Supply Line Bottlenecks and Breakages

Inflation is not always and everywhere a monetary phenomenon. Supply chains are fragile things. When COVID started ravaging China in January, the rest of the world thought that it would pass them by again, as it had with SARS in 2004. Initial fears were that the removal of productive capacity in China’s manufacturing heartlands on the back of forced shutdowns would lead to inflationary spikes if demand in the rest of the world was unaffected whilst supply was contracting, but we have now seen that disruptions to supply chains have created both inflationary bottlenecks and deflationary breakages. As an example, US beef prices have been impacted on both sides of the processing plants.

Closures of processing facilities have led to a collapse in demand for live cattle, putting downward pressure on cattle future prices: a deflationary break in the supply chain. Said in another way, US Live Cattle future prices fell because closures at processing plants reduced demand (not because consumers were consuming less beef).

But, the lack of processed meat has driven the price of wholesale beef to record levels (as you can see below): an inflationary bottleneck. This is a supply chain disruption, and not a monetary phenomenon, that has led to both inflation and deflation.

Damage to supply chains (and to your ability to consume daily Ribeye’s) is both inflationary and deflationary.

Supply without Demand: A Deflationary Inventory Build

Now that we’ve clarified that inflation is not purely a monetary phenomenon, let’s look ahead. What happens if manufacturing restarts, whilst demand remains sluggish? Although many remain suspicious about the speed with which Chinese macro data has recovered, some alternative data sources suggest that Chinese manufacturing had returned to 80% of its former pace by the end of April. International flights from China to the rest of the world, however, were around 25% of previous capacity.

Whilst we’re not comparing apples with apples, taken as a simple proxy for domestic manufacturing versus global consumer demand, this is a lopsided return to economic activity.

Within China, consumption patterns have lagged industrial output (people going back to work, but not to shops and theatres). This will lead to a build-up of inventory, initially positive for GDP and implying a rebound in growth, but it will also put pressure on margins because revenues will remain sluggish (consumers are not spending) and costs will start to normalize (production costs will come back).

After a period of inventory build-up, which will raise hopes of a fast recovery because increased inventories will boost GDP expectations, those inventories will need to be eventually cleared (getting people to buy more things). This will require more stimulus or lower prices (known as dumping), with the latter being easier than the former (see crude oil). If producers start lowering prices to clear inventories, it will lead to deflation, tighter margins and lower wages, which ends up being a grim scenario for the economy. The level of consumption and the tools needed to incentivize consumer spending will define what inflation will look like post inventory build-up, but one thing is likely to be true: a return to production without a return to consumption is deflationary.

Liquidity and Solvency: Balance Sheets and the Long-Term Debate

Recessions, bottlenecks and inventory pressure are often short-term trends. Longer-term trends in inflation will depend upon the size of monetary and fiscal stimulus. Longer-term trends in deflation will depend upon the scale of household and corporate insolvency.

Have balance sheets been damaged at the household, corporate and government level? A key question will not be about monetary inflation, but about monetary deceleration i.e. the velocity, not the amount of money.

The textbook equation for Velocity of Money is:

Even before the COVID-crisis, Velocity had been in a sharp decline because money supply was increasing at a faster rate than real GDP growth.

In today’s environment, GDP (the economy) is collapsing, whilst M2 (money supply) is accelerating, causing Velocity of Money to decrease. Velocity will fall much further as corporates offset lost revenues and hoard cash, in anticipation that future revenue streams could fall. Households will likely do the same, and postpone consumption to offset the level of debt they had built up over the preceding years.

Collapsing Velocity of Money will be deflationary. The relationship between the year-on-year changes in CPI and the year-on-year changes in the velocity of money implies that US CPI is going significantly lower (perhaps lower than in 2008).

To avoid deflation, governments need to stimulate aggregate demand to levels that are above and beyond where they were prior to the virus. Cash flows from governments to the private sector (corporates and households), however, are merely filling the void, helping to stabilize but not to stimulate the real economy, because businesses and households will be preoccupied with 1) plugging the immediate liquidity crisis (such as paying today’s mortgage or rent) at the expense of consumption and 2) hoarding cash in anticipation of future solvency issues (a decline in income or revenues).

The outlook for bankruptcies looks shocking. Expectations for a V-shaped recovery appear less likely as the lockdown drags on from Spring into Summer and economies edge toward normality in a series of baby-steps (and reversals). According to Thomson Reuters, 9.4% of Spain’s small businesses went bankrupt in March alone.

Alarmingly, the huge rise in US unemployment suggests a significant uptick in Chapter 11 bankruptcy filings.

Over the last forty years, the US consumer has proven to be remarkably resilient and the key drivers of economic growth (consumer spending contributes to almost 70% of US GDP). What happens if the consumer is forced to cut back?


Despite the post-GFC ‘recovery’, 45% of Americans have close to zero cash in their savings account (GoBankingRates Survey, December 2019).

Auto and student loans are at record levels, whilst credit card financing costs have soared (despite Fed funds being close to zero), pushing credit card delinquency rates to a twenty-year high, even before COVID struck.

Consumers have been teetering on the edge for years, living paycheck-to-paycheck. Despite this, consumption has remained the engine of US growth. Now, with paychecks abruptly postponed (and in some cases, cancelled),

many households will be missing rental, mortgage and credit card payments and also skipping on healthcare, setting in motion the dominoes in which their credit scores will be impaired. Banks, already hoarding cash, will be reluctant to lend.

Government handouts, which will be used to plug the hole in today’s cash flows, will be hoarded by consumers and companies in order to offset a decline in future revenue or wages, or used to offset debt. We can already see that the US savings rate is now at the highest level since the early 1980’s.

This behavior will be repeated up the chain. If households are hoarding, then corporate cash flows will be impaired as their revenue is impacted by the lower consumption from consumers. Corporates will therefore also hoard cash against a drop in future revenues. They will cut jobs and cut wages. Household balance sheets will be further impaired, forcing yet more retrenchment (cash hoarding). Banks will hoard capital rather than lend it to riskier corporates and consumers, exacerbating the dynamic.

Consumption patterns are unlikely to return to pre-COVID levels even if economies rapidly re-open because the crisis has revealed the underlying balance sheet fragility and may trigger a desire to de-lever. This would be deflationary.

If consumers and businesses retrench, can governments print fast enough to offset it?

Fiscal Infinity and Beyond: Can Monetary Inflation lift Velocity?

Print money. Create inflation. It sounds simple and many economists have been caught up in its siren call since QE kicked off in the last decade. Others call it ‘waiting for Godot’.

Printing money into an economy where demand is already tight and supply is stretched can certainly lead to inflation. The 1970s saw money printing that fueled baby boomer’s demand during an era of population growth and supply bottlenecks (both drivers of inflation). The 1940’s experienced inflation when the pent-up demand of a post-Depression and post-WWII era collided with a kick-starting stimulus.

Many economists worry about the world economy moving in the direction of stagflation (high unemployment and inflation) such as the one we had in the 1970s, but that was attributable to both bottlenecks as well as increases in money supply. Many western governments in the 1970s accounted for a larger share of their economies than they do today, a post-WWII legacy that offered welfare protection for workers, but which became unwieldy and over unionized, creating inflationary bottlenecks. (Implicit in this statement is that unions are typically less efficient at supplying goods, therefore creating price inflation through less supply of those goods). There was also a huge demographic tailwind, which led to a higher than expected level of demand. This all led to higher inflation.

The money printing of today, however, takes place in a world where excess consumption has been fueled by ever-increasing amounts of debt at the household, corporate and in many cases, government level.

If corporates and households are protecting against an expected decline in future cash flows, then governments will also need to offset declining revenues (tax receipts generated by taxed profits and incomes). Public pension liabilities (funding shortfalls) are again increasing and the deflationary hole is widening. Cash-rich tech companies, who have emerged as the COVID-19 ‘winners’ could now find themselves in the crosshairs of the public purse.

Private pension flows will be decreasing if incomes are falling (pension contributions are a luxury that will be reduced if income has fallen as covering today’s expenses becomes more important than planning tomorrow’s retirement). Corporate buybacks will be subdued compared to the pace of the last few years, though there will still be outrage when companies that furloughed staff continue to juice their shares for the benefit of the C-suite (heavily discussed in the Deep Dive). Even the ability to juice asset price inflation will face new structural headwinds.

Central banks are going to need a bigger and better targeted bailout. The US monetary response has already been exceptional in terms of both speed and size, but so far it looks like a supercharged repeat of the QE1, QE2 and QE3 programs we had in the last decade, which only helped the economy avoid a deflationary coma rather than get back on track of healthy growth. Ultimately, that prevented deflation but failed to curb the disinflationary trend.

Asset price inflation has once again materialized with the rebound in the tech-heavy NASDAQ. Expectations of central bank purchases have also levitated corporate bonds prices. This may hold back the tide for a while, but even during the GFC, the credit downgrade cycle peaked six months after Lehman (in Q2 2009). Downgrades today are already four times in excess of those levels, and we’re not at peak yet.

Instant cash is not an instant cure for the economy.

Here Come the Helicopters

Modern Monetary Theory, Universal Basic Income and Social QE (i.e. printing for the people rather than printing for the privileged) are on the horizon. ‘Infinite’ stimulus carries the specter of inflation – extended periods of money supply growth in excess of real output growth has led to inflation, when viewed over a longer time horizon, according to Tudor Investment Corp.

“There are only a few times in history when M2 growth exceeded real output growth over a 5-year span by the same or a faster pace than is currently the case: the inflationary periods of the 1970s–80s and the late 1940s”.

Earlier, however, we noted that these occurred after a period of pent-up demand (i.e. a return to consumerism after a period of lower spending) and peak demographic growth. Central banks today will need to work a lot harder because the existing backdrop is one of fragile debt, deflation and demographic dynamics. If consumer’s muscle memory – the desire to spend, spend and spend regardless of the economic backdrop – has been impaired, then additional government accommodation in the form of cash handouts could subdue productivity more than it will stimulate demand, because the money will go into savings rather than consumption, whilst saddling future taxpayers with an increased burden as they are the ones financing the government stimulus of today.

Inflation from Devaluation

Can central banks devalue their currency? A weaker currency should increase the demand for that nation’s goods and services whilst also stimulating inflation because of the higher cost of imports.

It optically seems like an easy way out, but for the largest central banks, devaluing is not an easy option. Currencies are always framed in pairs. The dollar against the euro, the pound or the yen. And so, who do Central Banks devalue against? If the US dollar devalues versus the Euro, the Euro devalues against the Yen and the Yen against the US dollar (ad infinitum), then no one devalues, but asset prices inflate.

For all the other central banks, devaluing their currency also has some limitations. If they try to devalue their currencies in order to make their exports more competitive in price in the hope of keeping up economic growth, they weaken their ability to repay their US dollar-denominated debt, increasing the risk of defaulting on their debts. The currency could then collapse. This is already happening. Brazil has been ravaged by COVID, whilst its export dependency has been exposed.

Emerging Markets (EM) weakness feeds back into US Dollar strength and to a lesser extent, Euro and Yen strength. Dollar strength feeds through to deflation.

One country’s deflation (e.g. USA) could be another country’s inflation (e.g. Brazil).

Summary: Sticky Deflation, Fleeting Inflation

We know this was a long article, so here’s a summary to help you remember what we covered.

The advent of inflation or deflation is, by far, one of the most challenging debates of today. This is what we know:

  • There will be inflationary bottlenecks, especially in heavy industries which are easily switched off, but take time to switch back on (mining, oil production, chemical processing).

  • There will be base effects, where today’s deflation becomes the starting point for tomorrow’s higher inflation. But that’s mechanical, rather than absolute.

  • There will be inventory imbalances when manufacturing returns at a faster pace than consumption, putting downward pressure on prices. This will be deflationary.

  • But before all of that, the first port of call is deflation as velocity collapses, caused by a hollowing out of demand given that the economic outlook will likely weigh on households consumption level.

  • The second port of call is also deflation, caused by future balance sheet impairment and the need to replenish the household and corporate coffers.

We’re going to need a bigger bailout.

  • Governments are battling a dynamic that is the polar opposite of the 1940s and the 1970s. Western consumers today are not starting from a point of weak demand prior to COVID, but one of excess demand that had been fueled by excess debt.

  • Monetary inflation and economic deflation can take place simultaneously. Asset prices might rise (could we get the S&P500 at 4000 and economic depression?).

  • Classical economist will continue to be confused by consumers who revert to how they should have acted for the last 20 years after the vagaries of the virus reveal the true extent of the excesses built up in the household, corporate and government balance sheets during the last couple of decades.

  • An acute inflationary bottleneck and soaring costs, if they materialized, could be the catalyst that forces a faster deleveraging and renewed drive toward a deflationary bust. Inflation would be a fleeting distraction.

  • This doesn’t mean that inflation will fail, but it will take a level of accommodation that is immeasurably superior to that which is currently on offer.

Households and corporates need to prepare for debt, deflation and defaults. Broad-based inflation is not the bogeyman of today and maybe not even tomorrow.