In this two-part essay, we look at the implications of the current crisis on the triumvirate of forces which we feel will drive economies and markets in the months and years ahead.  This week, we examine how dramatic increases in government debt and central bank activism can lead to deflation, inflation, or both. Next week, we will look at how these potential outcomes might affect currency markets, with a focus on the US dollar.

“We have always found, where a government has mortgaged all its revenues, that it necessarily sinks into a state of languor, inactivity, and impotence”

– David Hume, Philosopher and Economist, 1752

“The time is right for monetary finance…there is no limit on the money available”

– Adair Turner, former Head of the Financial Services Authority (UK), March 2020

According to data published by Nielsen last week, US prices are going up.  The price of fresh meat has risen by 8.1%, a pint of milk costs an extra 10.3%, and eggs are a whopping 31% more expensive than they were a year ago.  ‘Of course inflation is coming’ you might say.  Just look at what central banks around the world are doing.  The Fed is literally injecting $1 million into the financial system every second! 

However, financial markets remain untroubled (at least about the risk of inflation)– the 5 year / 5 year inflation swap rate is currently pricing a future inflation rate of just under 1.5% in the US, down by about 30 basis points from the start of the year.  So what is going on here?  Will a COVID-induced combination of supply shocks and helicopter money drive inflation higher?  Or are markets right to ignore hysteria about money-printing central banks, as we face a battle against deflation caused by a dramatic weakening of demand?

In the very short-term, a series of supply and demand shocks mean that prices are going up in some areas and down in others. As highlighted in the Nielsen numbers, grocery prices have gone up – likely due to a combination of supply shocks (e.g. processing plant closures due to the virus) and demand shocks (hoarding).  In other areas (travel), prices have collapsed – on average US airfares declined by between 10% and 20% in March.  These idiosyncratic shocks represent the noise rather than the signal.  They will be largely transitory and will moderate once the global economy settles into its ‘new normal’, whatever form that takes.

One factor that will not be transitory, is a huge increase in public debt.  In the US, the relief measures announced so far will push the deficit to about 20% of GDP, the highest level since World War II.   In turn, this will drive the US debt-to-GDP ratio to a level in excess of 120%.  And just the like virus, this expansion in government debt is not restricted to the US.  The IMF predicts that the gross fiscal debt of advanced nations will grow from about 105% of GDP to in excess of 120%.

This eye-watering increase in global debt is why the markets view deflation to be a bigger risk than inflation.   Research shows a clear negative relationship between government debt and growth.  This negative impact kicks in once debt- to-GDP levels reach 50%, and once they hit 90% then growth declines by about one-third against trend.  At debt-to-GDP ratios of above 120%, we can expect that this depressive impact on growth will become even more intense. 

There will be less investment (because there will be less savings to invest in productive enterprise as wealth is diverted to service the growing pile of government debt), leading to lower productivity and ultimately a lower standard of living.  The velocity of money will decline, as governments and businesses use their cash to service existing debt, instead of spending it on goods and services.

This is not an environment that we would typically expect to produce inflation, but rather it sounds more like classic debt deflation.   It is not like we haven’t seen this movie before either; this is exactly what we have been witnessing in Japan since the 1980s, and in the rest of the advanced economies since the 2008 financial crisis.  In fact, it is why everyone (including me) who predicted that the response to the global financial crisis over a decade ago would lead to inflation and /or stagflation was wrong.

Inflation, in the words of Milton Friedman, may well be ‘always and everywhere a monetary phenomenon’ but printing money, by itself, does not create inflation. Printing too much money (relative to demand) is where the risk of inflation arises.  The demand for money and the velocity of money are inversely related, so the declining velocity of money (as discussed above) means that sufficient demand is there to suck up the additional money supply being created by the Fed and the other central banks around the world as they increase the size of their balance sheets at a record pace.

So does that mean that the warnings about the (hyper) inflationary risks of increasing central bank ‘innovation’ are wide of the mark?    No, it doesn’t.  It merely means that the timing is important – deflation seems a more likely destination initially, but the road we are on may very well lead ultimately to inflation.

The first signs of an eventual inflationary risk came from the Bank of England last month.  After governor Andrew Bailey had rejected the concept of ‘outright monetary transactions’ only a few days before, the UK became the first country where the central bank has been permitted to directly fund the government’s response to the virus, bypassing the bond markets. 

This is a big step, and one which most independent central banks (including the Fed and the ECB) are expressly forbidden from taking.  Debt monetization is different from quantitative policy (like QE) in a very important way – the role of market forces is completely eliminated as the government sells bonds directly to the central bank.  This removes an important safety net that exists under QE, whereby there must at least be some market demand (albeit distorted) for government bonds.  This greatly increases the risk of the politicisation of monetary policy, as the central bank buys bonds as a substitute for market demand rather than as a mechanism to provide market liquidity.  

Such politicisation of the monetary system has been a reliable precursor to all past inflationary  / hyperinflationary episodes, from Weimar Germany to the US in the 1970s, to Zimbabwe in 2007.   As government debt loads become unsustainable, pressure will grow on governments and central banks to ‘innovate’ further. Witness the increasing profile of Modern Monetary Theory, or MMT, a hitherto obscure branch of economic theory, which holds, as Lord Turner claims above, that there is no limit on a government’s ability to print money.

In our view, the main forces that will drive market volatility and economic performance in the coming years will be debt, deflation (and inflation) and the US dollar.  These factors are intrinsically linked and their reflexive interactions will determine the direction and volatility of asset prices and real economic indicators for the foreseeable future.   Our view is that we will first experience a debt-induced deflationary shock (which will likely last for at least two to three years), followed by increasing inflationary pressure as governments yield to the siren song of debt monetization.

Next week we examine how we expect that these phases will impact global currency markets and the US dollar. 

Author: Kevin Lester