15th Jul 2022

Understanding the Differences Between Inflation, Deflation & Stagflation

By Andrew Lisa

July Fourth saw big crowds, congested highways and full airplanes as tens of millions of Americans celebrated not only the country’s independence but their own liberation from the pandemic. There were worries that creeping inflation would keep people home as the price of gas, meat and just about everything else ticked up — but the pessimists would not be vindicated. Inflation, after all, isn’t always bad — and it’s far from the only economic phenomenon that involves changes in the cost of stuff and the value of money.

Inflation: Your Incredible Shrinking Dollars

Economists use indicators like the consumer price index to measure inflation, but for you, all the data you need is right there at the grocery store, the gas pump or the coffee shop. Over time, the cost of goods and services gradually rises as the purchasing power of your dollars falls.

Some inflation is natural and inevitable, but too much can be harmful because when consumers can no longer afford to buy the things they once could, the national standard of living declines, and the economy declines right along with it.

But inflation can also be beneficial because it adds value to people’s assets even though their debt remains fixed. Inflation can also be a sign of a booming economy. During periods of growth, businesses are making money and hiring new workers, who then have more disposable income, which increases demand and sends prices up. When prices get too high, however, consumers cut back on purchases, businesses lose money and lay off workers, and the economy begins to contract.

Once Considered a Myth, the Misery of Stagflation Is Very Real

When prices rise in response to growing demand from cash-flush consumers in a booming economy, inflation can be good. But when rapid inflation coincides with high unemployment and slowing growth, as it did in the 1970s, the result is economy-killing stagflation.

During that time, America was experiencing crushing double-digit inflation, but not because the economy was expanding — quite the opposite. Soaring fuel costs sent the price of everything up just as the economy was contracting and more people were out of work, which most of the era’s economists simply didn’t believe could happen at the same time.

U.S. economic and monetary policy changed forever when the world saw what happened when a stagnant economy suffers runaway inflation (stagflation): back-to-back recessions, soaring prices, millions of people unemployed and a general sense that the country was coming unglued.

Deflation: Falling Prices Are Great — Until They’re Not

Just as it is with bicycle tires and air mattresses, deflation in economic terms is the opposite of inflation. During times of deflation, the cost of goods and services goes down and your dollars can buy more — sounds great, right?

Not so fast.

Policymakers and central banks fear deflation above all other outcomes because of a domino effect of destruction called deflationary spiral:

  • When prices are falling, consumers delay purchases to wait for them to fall some more.
  • When consumers stop buying things, production slows as demand falls.
  • When production slows and demand falls, prices drop, businesses lose money and lay off workers.
  • As unemployment rolls grow, consumers have less money and make even fewer purchases.
  • The cycle repeats itself, and the spiral continues until a downturn becomes a recession and a recession becomes a depression.

While Inflation Can Be Bad, Deflation Is Always Terrible

Modest inflation is a natural part of the economic cycle that might be good news, bad news or no news at all — but deflation is always a reason for worry. While it’s true that inflation makes things more expensive, it also lowers the value of debt, so people and businesses don’t stop borrowing money. Plus, you can fight back against inflation by investing your money — when things get more expensive, your assets are no exception and become more valuable.

Deflation, on the other hand, lowers the cost of everything, including the assets of people and businesses. The more assets lose value, the more expensive debt becomes, so people and businesses stop borrowing money, which strangles the economy even further.

In a world where everything is losing value except debt, money has few safe places to hide. 

READ MORE: Yogi Berra and the Inflation Conundrum: It Ain't Logistics or the Supply Chain By Bruce Kamich

I worked for a commodity consulting firm from 1973 to 1976. This was my first job out of university. I learned about the supply and demand for everything from cotton and live cattle to soybeans and zinc.

I learned about supply/demand tables, yields per acre, fundamental analysis, quantitative analysis and technical analysis. It shaped my thinking about the markets in a way that has influenced me the past 49 years.

In the 1970s inflation was driven by a number of supply shocks and a program in Washington of guns and butter. In the '70s and '80s there was a path to more supply and it was higher prices. Higher prices eventually produced more supply. More supply took planting more crops, using more fertilizer, raising more cattle, opening new mines in far-off lands and drilling for more oil in harsher environments. Eventually commodity prices were tame for decades and "just in time inventory" became wildly popular.

Over the years this link of high prices and more supply got broken. Oil prices and other commodities such as copper soared in price but CEOs got burned when prices quickly changed direction as deflation became ingrained.

Another issue has grown quietly in the past 20 years. There are now 1.6 billion more people on the planet since 2000.

Along with this global population growth we are seeing a huge growth in the middle class. By 1975 the middle class had reached 1 billion people. By 2006, another 1 billion had joined the middle class, and now less than a decade later, we are at 3 billion. The middle class could surpass 4 billion this year, making it a majority of the world's population according to data from the U.N.

Supply shocks are now being met with insatiable demand. Millions, no billions of people have moved away from rice and tofu to chicken and beef and fish, which take more resources to produce. People have moved away from bicycles to mopeds to little cars to big SUVs. All of these things take more stuff to produce. This level of demand did not exist in the 1970s but it is a clear and present issue today.

And let's add in the fact that U.S. farmland under cultivation has been going down in the world's breadbasket from 945,080,000 acres in the U.S. in 2000 to 896,600,000 in 2021.

In my early commodity days I learned that corn grain yield improvement began in the mid-1950s in response to continued improvements in genetic yield potential and stress tolerance plus increased adoption of nitrogen fertilizer, chemical pesticides, agricultural mechanization, and overall improved soil and crop management practices.

Further improvement in yields to feed the world's billions may prove elusive as people reject GMO crops and prefer organic produce with lower yields.

Water for agriculture is a growing problem throughout the world and not just in California.

Turning to the price of gasoline and other fuels there are refinery issues -- not keeping up with demand. In 2020, oil refinery capacity in the United States amounted to approximately 18 million barrels per day. Although refineries are operating at full capacity, they may still have difficulties in meeting daily energy demands.

Chile is the world's largest copper producer and while the country may be a welcome home of democracy in Latin America, protests could topple the government and turn to a dictatorship again. Imagine what could happen to copper prices if this key source was disrupted.

Yogi Berra used to say "It's like deja vu all over again." Well, it is inflation all over again but high prices are not producing more supply and demand is off the charts. Price will be used to ration supply and the path to more supply is broken or now takes even longer to produce results.

It is not the supply chain -- we need more supply not just more truckers to move this stuff to homes and super markets.

How high could prices go?

READ MORE: Don’t let them tell you inflation is good for the poor. It’s not By Gustavo Flores-Macias

In October, U.S. inflation reached 6.2%—a 30-year high. Unless the Federal Reserve and the Biden administration change their current approach, the consequences of these inflation levels are likely to be most severe for the most disadvantaged sectors of society—the poor, women, and underrepresented minorities.

Authorities were rightly worried about a major economic contraction resulting from the pandemic, which is why the Fed and the government adopted monetary policies and fiscal policies aimed at stimulating the U.S. economy. The worry until recently was not that prices would rise, but that they would fall too much, as with Japan’s deflation. Free-falling prices are a concern because they lead to lower spending as consumers wait for better prices in the future.

Out of this inertia and worried about interrupting economic recovery prematurely, the Fed has dismissed concerns about rising inflation, pointing instead to its transitory nature. This is in line with a chorus of opinions exalting the benefits of inflation. As a former managing director of Blackrock put it, “Many Americans, particularly the less wealthy, actually stand to benefit from higher levels of inflation.” The intuition is that wages have risen steadily during the pandemic and inflation erodes the value of household debt, improving the purchasing power of salaried workers and reducing their debt burden.

With annual inflation below 5% in the past three decades, about half of the total U.S. population has no experience with high inflation. The median age is 38. People who have not lived through inflation find it difficult to concretely grasp its consequences. Although the rosy picture exalting the benefits of inflation might initially resonate with those concerned about poverty and inequality, the reality is more complex.

There are three important problems with letting inflation run high.

First, inflation has important distributional consequences, disproportionately hurting the least affluent sectors more than the wealthy. Although inflation erodes everyone’s purchasing power, the wealthy tend to own assets better able to weather inflationary periods. The price of real estate assets, for example, tends to appreciate with the general price increases in society, and rental income can be adjusted to keep up with the rising cost of living, providing property owners some protection against inflation. The wealthy also tend to have access to hedging mechanisms against inflation, such as shifting assets abroad, trading currency, or purchasing gold and cryptocurrencies.

Conversely, the working class depends on wages and salaries staying above inflation, which is difficult to obtain in practice once an inflationary spiral takes hold. Indeed, rising inflation has already eroded the early pandemic wage gains of American workers, and real worker compensation is now lower than its pre-pandemic trend.

Second, as inflation rises, so does the cost of reining it in. And as inflation expectations become entrenched, a greater effort is required to put a lid on it. That’s what happened in the Latin American experience during the ’80s and ’90s. Agreements between business groups and labor unions pledging to maintain price and wage levels failed repeatedly because nobody believed others would comply. In the U.S., a New York Federal Reserve survey points to expected inflation at 5.7% a year from now—the highest since data collection began in 2013.

In inflationary cycles, governments then have to adopt more stringent measures, which also tend to affect disadvantaged groups disproportionately. Steeper interest rate hikes and reductions in fiscal spending result in a harsher slowdown of economic activity, with layoffs and a higher cost of borrowing affecting more of those living paycheck to paycheck.

Third, inflation is not merely an economic phenomenon. It also leads to pervasive political and social consequences. High inflation generates generalized uncertainty and anxiety about one’s own future. Higher prices at the grocery store or the gas pump, as well as higher rent and heating bills become everyday reminders of this uncertain future, especially among the poor who are least able to protect themselves against unforeseen events.

Since all politics is local and people feel these effects directly in their pockets, it is not surprising that inflation is notorious for hurting political incumbents. Research consistently points to inflation as a key consideration affecting voting decisions, with incumbents paying a price for their inability to rein it in. In the U.S. about six in 10 respondents already call the state of the economy poor.

Because of its harmful consequences for the disadvantaged, the high costs of reining it in once it is high, and the social and political costs it generates, inflation must be addressed before it becomes more of a problem. Both the Biden administration and the Fed have a shared responsibility to act.

If the Biden administration will inject much-needed resources into the economy for infrastructure, environmental, and social spending, it must do so judiciously. In turn, the Fed must be swift in tightening monetary policy before inflation gets out of control. By the time we have certainty that inflation is not temporary, it will have been too late for its smooth management, and those who have the least will be stuck with the bill.

Forbes: Since the onset of Covid, Uncle Sam has poured more than $5 trillion (and counting) into the economy. The flood of money was so immense that it did more than save the “grounded” economy. In one of history’s biggest economic shocks, it made Americans—at least in dollar terms—richer than ever.

The government claims to have poured $6 trillion in relief since the pandemic started BUT where is it? Where did all of that money go? Can you see $6 trillion anywhere? New cars, new buildings, do your neighbors have new clothes? Credit cards all paid off? WHERE DID $6 trillion go? READ MORE: Billionaires won big with the coronavirus stimulus (Salon) and Why the Trillion-Dollar Coronavirus Bailout Benefited the Rich (Time)

When you have more dollars chasing fewer goods and services you have inflation. And the only tool that the FED has to fight inflation just happens to be? Raising interest rates, which the FED has done since Biden took office. But raisng interest rates has also made the stock market go down.

In 2018 Trump threatened to fire the FED chairman Jermome Powell unless he stopped raising interest rates. Powell backed off and in exchange Trump and Powell pumped 6 trillion dollars of stimulus money into the global economy creating todays inflation. READ MORE: President Trump Reportedly Discussed Firing Federal Reserve Chairman Over Interest Rates and Stock Market Losses (Time) and Trump battled the Powell Fed's rate hikes. Biden's betting on them (Yahoo News) and Introducing the ‘Great Reset,’ world leaders’ radical plan to transform the economy (The Hill)

More than $1 trillion made its way into personal bank accounts through direct stimulus payments and advance Child Tax Credits alone. 

Prices soon began increasing across the entire economy, and not long after, inflation was rising at its fastest rate in 40 years. It’s easy to draw a straight cause-and-effect line between the two events.

Even the Federal Reserve Bank of San Francisco, estimated at the end of March that government stimulus may have added three percentage points to the national inflation rate.

Factory closures from early in the pandemic reduced supply just as demand was rising, which sent prices up even further.

Two indisputable facts:

  • No country distributed anywhere near as much stimulus money to its people as the United States
  • No country was hit as hard by rising inflation as the United States

According to the International Monetary Fund (IMF), “If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise.”

The IMF elaborates with this: “Supply shocks that disrupt production, such as natural disasters, or raise production costs, such as high oil prices, can reduce overall supply and lead to ‘cost-push’ inflation, in which the impetus for price increases comes from a disruption to supply.”

Do yourself a favor. Think for yourself. Be your own person. Question everything. Stand for principle. Champion individual liberty and self-ownership where you can. Develop a strong moral code. Be kind to others. Do no harm, unless that harm is warranted. Pretty obvious stuff...but people who hold these things in their hearts seem to be disappearing from the earth at an accelerated rate. Stay safe, my friends. Thanks for being here.

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