Deflation or Inflation? Take Your Pick...

There is quite a bit of debate over the question of whether we are headed for a deflationary or inflationary future in the aftermath of the global economic shock inflicted by COVID-19 pandemic (or, to be more precise, the lockdown measures that have been implemented in response to it). The fact is that nobody knows. As with any complex system, predicting the future of the global economy accurately, even with the most sophisticated computer models at hand, is impossible. At most, we can take an educated guess.

A few weeks ago, on April 22nd, we published an article titled “Buckle Up: The "Stuckflation" Roller Coaster Straight Ahead!” We received quite a few comments and feedback on that. I’d like to thank all who took the time to share their views. One comment, or question, appeared dominant and boiled down to this: “Do you expect inflation to pick up?”.

In the article, I did not actually express a point of view on that. However, the term “stuckflation” - or at least the “flation” part of the term - appears to have triggered the interest in the inflation vs. deflation question.

I wish I had a clear and short answer to that question. Unfortunately, my immediate and honest answer to that would be that I don’t know. However, I do have to say that, at this point and in the shorter to medium term – and if I were a betting man – I would put my money on a deflationary period, and possibly a long and painfully extended one.

On the other hand, as we know from history, in highly imbalanced and uncertain economic times, tensions can discharge, and forces can pivot in rapid and unexpected ways. So, I would certainly not rule out a sudden rise in inflation, and ultimately even a hyper-inflationary fallout in the longer-term.

The COVID-19 shock has resulted in forces that pull both ways

In brief, the supply shock induced by faltering supply chains (inflationary), needs to be weighed against the fall in aggregate demand (deflationary). Measuring the scale of these forces is difficult. So far, according to Reuters, U.S. consumer prices posted their largest drop in five years amid coronavirus disruptions.

The COVID-19 crisis impact on price inflation – so far

Source: Reuters

Here are a few factors that contribute to price inflation:

  • The US Federal Reserve and other global central banks and governments are inducing unbelievable amounts of liquidity. The US Fed is said to have created a $6 trillion (!) stimulus.

  • Supply chains, nationally and even more so internationally, have been disrupted. In a globalized world as ours, the domino effects and collateral damage are hard to measure. The drop-off in production and output, ceteris paribus, should result in higher prices of goods and services.

  • Inflation expectations have been on the rise. Rising inflation expectations are generally seen as an early indicator of inflation on the horizon. One reason for rising inflation expectations is de-globalization and a “second round” of trade wars with China. Only this time, it appears that Europe is siding with the US administration, which means that one might expect a deeper restructuring of supply chains, in an effort to be more independent from China, and more self-sufficient in the production of goods considered strategically critical.

Then there are factors contributing to price deflation:

  • According to The Wall Street Journal, 20.5 million US jobs (!) have been shed so far in this crisis. The April unemployment rate rose to a record 14.7% eclipsing the previous record rate of 10.8% for data tracing back to 1948. Unemployment of course dampens consumption.

  • Equally, incomes falling and firms going out of business due to the lockdown are lowering demand, creating a deflationary impact.

  • Finally, money velocity continues to be at record lows and continues falling. Therefore, Federal Reserve measures are like pushing on a string. They continue to fail ramping up the real economy.

And there are more variables, of course. Some observers point to lower commodity prices, particularly record low oil prices. Others mention the very large increases in fiscal deficits and central bank balance sheets and foresee inflation, perhaps even high inflation. So, what is our expectation at BFI?

The significance of low money velocity

At BFI, over the next 12 months, our most probable scenario is a deflationary recession. Over the next 12 to 24 months, we expect the “stuckflation” scenario, as discussed in our aforementioned article from April. It entails a mix of deflationary and inflationary tendencies. In the longer term, the chances of growing inflation will increase. And, unfortunately, the chances of a Weimar Republic type scenario, i.e. an extended depression with bouts of high inflation, is in the cards.

But, for now, the next stop appears DEFLATIONARY RECESSION to us. Why is that:

Over the past decades, the deployment of increasingly activist fiscal and monetary policy have become the primary tools recommended by economists and politicians alike in response to every crisis and in order to combat unemployment. This Keynesian approach to “managing” the economy has become a global phenomenon and has taken on a somewhat religious character.

Today, it is hard to argue for any form of truly free-market cycle, or the necessity of austerity. The voices that air such suggestions are shunned and eliminated, similar to those voices that might dare to suggest a non-consensus approach to dealing with the issues of global warming.

To be fair, Keynes developed his economic theory in response to the Great Depression. And, clearly, the policies that emerge on the basis of that theory have been successful in staving off recessions, or at least saving the financial markets. However, the question is at what price? Will the collateral damage and growing economic control of government ultimately lead to a kind of planned economy and socialistic regime? If so, we all know from plentiful empirics what that leads to, economically and socially.

Total Federal Reserve Assets

Source:, Board of Governors of the Federal Reserve System (US)

But I digress. In order to once again “manage” the economy and avoid economic pain, the central banks have opened the money faucet yet a little more. As can be seem in the chart above, another $2 trillion have been added to the Fed’s balance sheet within the past two months alone. This monetary stimulus dwarfs what the Fed did in the 2008/2009 crisis.

More and more cheap money is pumped into the system. Interest rates are at record lows. Government bonds have yields at or below zero. The question is: Will all this extra liquidity lead to more growth?

M2 Money Stock (in billions of Dollars)

Source:, Federal Reserve Bank of St. Louis

Velocity of M2 Money Stock

Source:, Federal Reserve Bank of St. Louis

We doubt it. Increased liquidity has long ago stopped helping prop up GDP. It has mostly supported the price of financial assets, faithfully propping up stock markets and financing debt at a continuously lower price tag (interest rates). Why? Well, the problem is again a multi-variable one. However, here is a somewhat simplified equation of the Quantity Theory of Money. Possibly, it can help to explain:

M*V = P*Q

Where: M = Money Supply V = Velocity of Money Circulation P = Average Price Level

Q = Volume of Transactions of Goods and Services​

In brief, to simplify, one could say that Money Supply times Money Velocity equals GDP. So, if money velocity remains the same, the theory suggests that an increase in money supply will increase GDP.

So, where does money velocity come from? It comes from such things as innovation, efficiency and entrepreneurship, things that increase the viability and vigilance of an economy. On the other side of that, you find bureaucracy, regulations and a high state quota, i.e. a large or growing share of the public sector. Moreover, a lack of confidence in one’s economic future, for example based on rising fears of losing one’s job, will lower money velocity. This will mean that people save more. They don’t spend. As portrayed in the chart below, the US is currently witnessing the highest personal savings rate in almost 40 years.

US Personal Savings Rate (April 30, 2020)

Source:, Federal Reserve Bank of St. Louis

Money velocity has been in an extended downward trend. And, this trend is not unique to the American economy. Based on the increasing encroachment into the private sector of governments globally , Money Velocity is being killed. Therefore, quite logically, in order to support GDP and avoid recessions, an ever-increasing amount of money is required, at an ever-decreasing price (interest rate). However, increasing money supply while velocity shrinks is like pushing on a string. Central banks are getting “less and less bang for the buck”.

Until velocity picks up, or other factors result in higher interest rates, we doubt that we will see an end of a deflationary scenario. Chances are quite high that deflation will reign supreme for some time. That does not mean that inflation should be ruled out. We know for sure that literally the entire developed and much of the emerging world is going through a monetary and fiscal expansion like never before. In a way, it is like a universal basic income, financed by Modern Monetary Theory. Ultimately, that is inflationary by nature.

In conclusion, the longer and deeper the recession, which is currently unfolding, runs its course, the higher the probability we give for increasingly inflationary forces. In any case, as we move forward, a prudent investment strategy will calculate and consider the implications of both, inflation and deflation!