Rickards: A central banker’s worst nightmare

Inflation and deflation are two sides of the same coin. Inflation is marked by generally rising prices. Deflation is marked by generally falling prices. Both are deviations from price stability, and both distort the decisions of consumers and investors. In inflation, consumers may accelerate purchases before the price goes up. In deflation, consumers may delay purchases in the expectation that prices are going down and things will be cheaper if they wait.

Both inflation and deflation are challenging to investors who have to guess future returns based on changes in price indexes in addition to navigating the normal business risks of any investment. Inflation favors the debtor because the real value of his debts goes down as money becomes worth less. Deflation favors the creditor because the real value of amounts owed to him goes up as money becomes worth more. In short, both inflation and deflation make economic decisions more difficult by adding a wild card to the deck.

To investors, inflation and deflation are bad in equal, if opposite, measure. But, from a central banker’s perspective, inflation and deflation are not equally bad. Inflation is something that central bankers consider to be a manageable problem and something that is occasionally desirable. Deflation is something central bankers consider unmanageable and potentially devastating. Understanding why central banks fear deflation more than inflation is the key to understanding future central bank monetary policy.

Central bankers believe they can control inflation by tightening monetary policy, usually by raising interest rates. Since rates can be raised to infinity, there is no limit on this tool. Therefore, no matter how strong inflation is, central banks can always tame it with more rate increases. The classic case is Paul Volcker in 1980 who raised interest rates to 20% in order to crush inflation that had reached 13%. Central bankers feel that if the inflation genie escapes from the bottle, they can always coax it back in.

Central banks also believe that inflation can be good for an economy. This is because of something called the Marginal Propensity to Consume or MPC. The MPC is a measure of how much an individual will spend out of an added dollar of income. The idea is that if you give a poor person a dollar they will spend all of it because they struggle to pay for food, housing and heath care. If you give a rich person a dollar, they will spend very little of it because their needs are already taken care of, so they are more likely to save or invest that dollar. Based on this, poorer people have a higher MPC.

Inflation can be understood as a wealth transfer from the rich to the poor. For the rich person, his savings are worth less, and his spending is about the same because he has a low MPC. By contrast, the poor person has no savings, and may have debts that are reduced in real value during inflation. Poor people may also get wage increases in inflation, which they spend because of their higher MPC.

Therefore, inflation tends to increase total consumption because the wealth transfer from rich to poor increases the spending of the poor, but does not decrease spending by the rich who still buy whatever they want. The result is higher total spending or “aggregate demand” which helps the economy grow.

Deflation is not so benign and hurts the government in many ways. It increases the real value of the national debt making it harder to finance. Deficits continue to pile up even in deflation, but GDP growth may slow down when measured in nominal dollars. The result is that the debt-to-GDP ratio can skyrocket in periods of deflation. Something like this has been happening in Japan for decades. When the debt-to-GDP ratio gets too high, a sovereign debt crisis and collapse of confidence in the currency can result.

Deflation also destroys government tax collections. If a worker makes $100,000 per year and gets a $10,000 raise when prices are constant, that worker has a 10% increase in her standard of living. The problem is that the government takes $3,000 of the increase in taxes, so the worker only gets $7,000 of the raise after taxes.

But if the worker gets no raise, and prices drop 10%, she still has a 10% increase in her standard of living because everything she buys costs less. But now she keeps the entire gain because the government has no way to tax the benefits of deflation.

In both cases, the worker has a $10,000 increase in her standard of living, but in inflation the government takes $3,000, while in deflation the government gets none of the gain.

For all of these reasons, governments favor inflation. It can increase consumption, decrease the value of government debt, and increase tax collections. Governments fear deflation because it causes people to save, not spend, it increases the burden of government debt, and it hurts tax collections.

But, what is good for government is often bad for investors. In deflation, investors can actually benefit from lower costs, lower taxes and an increase in the real value of savings. As a rule, inflation is good for government and bad for savers; while deflation is bad for government and good for savers.

There are many flaws in the way the government and economists think about inflation and deflation. The idea of MPC as a guide to economic growth is badly flawed. Even if poor people have a higher propensity to consume than rich people, there is more to economic growth than consumption. The real driver of long-term growth is not consumption, but investment. While inflation may help drive consumption, it destroys capital formation and hurts investment. A policy of favoring inflation over deflation may prompt consumption growth in the short run, but it retards investment led growth in the long run. Inflation is a case of a farmer eating his own seed-corn in the winter and having nothing left to plant in the spring. Later he will starve.

It is also not true that inflation is easy to control. Up to a certain point, inflation can be contained by interest rate increases, but the costs may be high, and the damage may already be done. Beyond that threshold, inflation can turn into hyperinflation. At that point, no amount of interest rate increases can stop the headlong dash to dump money and acquire hard assets such as gold, land, and natural resources. Hyperinflation is almost never brought under control. The typical result is to wipe out the existing currency system and start over after savings and retirement promises have been destroyed.

In a better world, central bankers would aim for price stability that does not involve inflation or deflation. But given the flawed economic beliefs and government priorities described above, this is not the case. Central banks favor inflation over deflation because it increases tax collections, reduces the burden of government debt and prompts consumption. If savers and investors are the losers, that’s just too bad.

The implications of this asymmetry are profound. In a period where deflationary forces are strong, such as the one we are now experiencing, central banks have to use every trick at their disposal to stop deflation and cause inflation. If one trick does not work, they must try another.

Since 2008 central banks have used interest rate cuts, quantitative easing, forward guidance, currency wars, nominal GDP targets, and Operation Twist to cause inflation. None of it has worked; deflation is still a strong tendency in the global economy. This is unlikely to change. The deflationary forces are not going away soon.

Investors should expect more monetary experiments in the years ahead. A Fed rate hike in 2015 seems unlikely given recent weak data. If the Fed nevertheless raises rates despite weak data, possibly from fear of asset bubbles, global market reaction may be extreme including a sudden bursting of those bubbles. A fourth round of quantitative easing, so-called “QE4,” perhaps in early 2016 cannot be ruled out. If deflation is strong enough, central banks may even encourage an increase in the price of gold by 2017 in order to raise inflationary expectations.

Eventually the central banks will win and they will get the inflation they want. But it may take time, and inflation may turn into hyperinflation in ways the central banks do not expect or understand. This “tug-of-war” between inflation and deflation creates the most challenging investment climate in eighty years. The best investment strategies involve a balanced portfolio including hard assets and cash so investors can be ready for all possible outcomes.

James Rickards is the editor of Strategic Intelligence, a monthly newsletter, and Chief Global Strategist at West Shore Funds.

 

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