The Great Inflation Debate

The great investment debate of today is about the future course of inflation. Economists and investors are divided into the “inflationistas” and “deflationistas.” The former, “Team Permanent,” see the recent surge in inflation as indicative of a regime change towards a world of supply scarcity and higher prices.; the latter, “Team Transitory,” believe we are stuck in a low growth and demand-constrained environment where prices always fall unless monetary authorities intervene.

Until recently, the “deflationistas” were triumphant. Fears that the money printing and fiscal expansion that followed the Great Financial Crisis would spark inflation never materialized. The past ten years have been marked by low inflation and a strong dollar despite zero bound nominal interest rates. The core argument of the “Deflationistas,” as expressed by economist luminaries such as Paul Krugman and former Fed Chair Ben Bernanke, is that inflation is repressed by declining growth in the working age population. This phenomenon, sometimes called “secular stagnation” or also “the global savings glut” has supposedly brought down the “natural rate of interest” which preserves price stability.

Deflation has been the norm for so long that it is understandable that most people assume that it will persist.

Since the U.S. Consumer Price Index (CPI) peaked at 15% in the spring of 1980 it has been on a persistent downward trajectory. This has been dubbed “The Great Moderation” by Bernanke who attributed this result to the masterful management of the Fed and its 400 economists.

The contribution of the Fed to the deflation process is difficult to confirm because of the various other factors that have concurrently impacted prices over the period. These are well known, but we list them below:

The collapse in commodity prices. Energy prices fell by 80% during the 1980s and remained low until 2002. Following the GFC, the U.S. shale revolution drove energy costs in the U.S. to near record lows.
The baby boom labor expansion which was magnified by a huge increase of the female participation rate in the labor force, and also by record levels of legal and illegal immigration.
The rise of China under Deng (1982) and the fall of the Berlin Wall (1989), which added nearly a billion low-cost workers to the global economy. China’s debt-fueled mercantilist industrial promotion policies also dramatically increased global production capacity for a wide variety of industrial goods.
Hyper-globalization, driven by declining transportation and communication costs and chronic U.S. current account deficits. Outsourcing has been highly deflationary, lowering labor costs of goods and putting downward pressure on domestic wages.
Hyper-financialization, driven by the Washington Consensus for open global capital and labor markets.
The Reagan-Thatcher Neoliberal Revolution which drove prices down through deregulation, the defenestration of labor unions and lower taxes.
Lax anti-trust policy which incentivized corporate concentration . This was further accentuated by the emergence of “winner-take-all” network-driven technology business models.
Digitalization of consumption through technology.

Over this long 40-year deflationary period, different forces have dominated at different times. For example, in the 80s declining commodity prices, deregulation and abundant labor were the dominating forces. However, in the 00s, the “China supply shock” (including cheap Chinese labor) and hyper-financialization were the dominant forces, overwhelming the temporary surge in commodity prices.

Some of these deflationary forces are still operative today. Foremost, technology continues to be deflationary as digitalization spreads wider (entertainment, office work, medicine, etc…) and communications facilitate offshoring (eg. IT in Bangalore). Supposedly accelerating technological disruption is now the key argument of many deflationistas (e.g. Cathie Wood of Ark Investments), even though over the past decades this was probably of secondary importance to the overall deflationary trend.

There is also a major new source of deflation, which is the high levels of debt accumulated around the world and, consequently, the collapse in “money velocity” (the creation of money through commercial bank lending). Though this is a controversial topic with economists, there are reasons to believe that the very high levels of debt around the world repress future economic growth. This is manifested by the decline in the money expansion created by bank lending over the past decades, and it explains why quantitative easing has had little impact on consumer prices. It may well be that debt levels are so high that any effort to raise real interest rates by central banks will tank economies. This view, pushed by the investor Ray Dalio, assumes that we have reached the peak of a long-term debt cycle.

On the other hand, there are new inflationary forces and some of the powerful deflationary forces of recent decades may have lost steam. These inflationary factors can be listed as follows:

Commodity prices have surged recently and may continue to rise because of underinvestment caused by regulations and ESG lobbying. The shale revolution in the U.S. may have peaked out and may no longer provide a source of low-cost marginal production.
Labor in developed countries is now tight because of ageing populations, a decline in female participation rates and anti-immigration policies. The working age populations in most developed countries and in China are now in steep decline which should increase the cost of labor if productivity does not compensate.
Hyperglobalization may be under threat as reliance on China and other Asian manufacturing hubs is increasingly seen as irresponsible in an increasingly fraught geopolitical environment.
Hyperfinancialization is under question as unfettered capital flows have proven to be highly disruptive for both the United States and most emerging markets. Over this long deflationary period, chronic current account deficits have made the U.S. a net debtor to the world with a Net International Financial position going from positive 10% of GDP in 1981 to negative 86% of GDP in 2021.
The neoliberal revolution may have exhausted itself. Labor unions are showing signs of making a comeback and tax cuts have resulted in chronic deficits and record debt levels. Also, there is a growing realization that without government interference the U.S stands to lose jobs and stature to countries which actively support industries through subsidies and mercantilist policies (e.g. semiconductor manufacturing which may soon disappear from the U.S. unless the government supports it). Moreover, there are some signs of a resurgence in anti-trust efforts from Washington.

The debate between the “deflationistas” and the “inflationistas” will not be settled anytime soon. There are simply too many moving pieces and competitive forces at work to have high conviction now. Nevertheless, for the first time in decades the Fed may no longer have the wind at its back and the luxury to print trillions of dollars to support economic activity and financial markets. If the Fed is faced with the choice between supporting the economy and financial markets or controlling inflation, political pressures will guide its decisions. In a world of populist politics this may mean higher prices in exchange for more government spending and higher wages.

The charts below show the inflation story in pictures.

Deflation has been a global trend since the 1980s.