Is it Time to Prepare for Deflation?

Not many investors are worried about deflation. Markets expect central banks to continue to raise rates as wage growth remains high. And inflation is still running at multiples of central bankers’ targets anyway.

But what if the same indicators that could’ve (and should’ve) warned you about our inflationary spike in 2021 are warning about deflation today? Would you listen to them this time around?

In June of 2020, I warned readers that, ‘Inflation is back, with a vengeance’. And in June of 2021 I reiterated this warning by telling subscribers that it’s time to ‘Prepare for an inflation spike unlike any you’ve seen before’. Within weeks of my final warning, inflation began to take off, causing many of my predictions made back then to come true:

‘But I warn you, our conclusions will sound extreme. We may be in for a spurt of inflation so large it’ll have destabilising effects globally in a myriad of ways. It could even be a surge in prices greater than any of you have seen before, including those who recall the 70s.

‘Dictators will be assassinated, governments will fall, companies will go bust, government treasuries will default, riots will break out, pensions will become worthless, bond markets will crash, money will be shunned, interest rates will spike and stocks will go haywire.’

Since then, we’ve seen double digit inflation in some developed countries, bond prices crashed and stocks plunged in 2022, the UK government came undone due to a bond market crash, sovereign debt defaults are at a record high, protests and riots over inflation are common, interest rates were hiked to an impossible level and a report released by financial market research firm Stock Doctor found that 70% of ASX-listed companies are ‘at serious risk of failure’ after a huge jump in ASX-listed companies having to call in the administrators already.

Of course, the methodology for measuring inflation has changed radically since the 70s, so it’s not clear whether our inflationary spurt really outdid the peak of that period. But what made the 70s dangerous was the repeated bouts of rising prices.

Today, I’m getting worried about the opposite. What’s intriguing is that it’s for the same reasons…

Back in 2021, it was producer price indices (PPI) which first alerted me to the coming inflationary shock. Sure, the monetary shenanigans that would go on to fuel the inflationary shock was important. As was the drop in the velocity of money during the pandemic lockdowns. But it was what’s known as ‘factory gate prices’ — the inputs of producers — which spiked first.

In the US, the PPI spiked to previously unseen rates of increase in January 2021, just one month before the consumer price index (CPI) began to surge too. The same in the UK and Europe, although Australia was several steps behind.

The point is that inflation was a supply shock, meaning the cost of producing things soared, leading the price of consumption items to increase subsequently. This differs dramatically from the usual sort of inflation — when prices rise because the value of money is falling or because people are buying too much.

That also explains why central bank interest rate hikes didn’t really work to slow down inflation. Central banks can’t produce more lumber, oil or car parts. They can only solve demand related problems, not supply.

But enough of the past. What about the future?

Actually, it’s the more recent past I’m focused on. You see, producer price indices in some of the countries that led us into inflation are falling in some countries. Not to lower rates of increase — prices are actually falling. The UK ticked over to declines in June, with a further confirmation since. Germany’s PPI, which spiked more than others’ preceding the inflationary surge, is now crashing. While CPI remains above 6%, PPI is down 12.6%!

Now, it’s not fair to say that supply side issues are the only factor behind inflation today. But if they were the key cause of the inflationary spike in 2021, then deflation in the same measures would certainly add a lot of weight to the argument that inflation is about to crash.

It’s worth noting that inflation recently turned a corner back up in the US. Which might imply inflation is not yet over. But I suspect a lot of that CPI increase has come from the oil price, which is surging. The thing is, peaks in the oil price tend to precede deflationary shocks as the high energy price slams the breaks on economic growth. So high oil prices may also signal an impending slowdown too.

There are other signs of deflation. House prices which spiked during the pandemic are trending down in many places, especially in real terms. Indeed, many markets, from commodities to stocks, didn’t rise much in real terms over the past few years. It seems that, instead of a crash in asset prices to correct for pandemic run-ups, the value of money fell post pandemic.

GDP is also waning, especially in Europe, while Australia is in a per capita recession. Construction is cratering in many economies. Bankruptcies and defaults are rising.

There’s also plenty of bad news yet to come with mortgages resetting to higher and higher rates, the end of student loan forbearance in the US and higher interest rate costs for governments filtering through as their debt rolls over.

Perhaps most importantly, after being humiliated for failing to predict inflation, central banks are now on a warpath against it. They won’t give up lightly, even if it means flogging a dead horse.

So, is it time to prepare for deflation instead?

I think it’s time to prepare for both extreme outcomes — high inflation and deflation. That’s because governments and central banks are walking on a tightrope between the two, but the load is getting ever heavier.

On the one hand, the economic cycle has been dominated by a particular pattern for decades now. Central banks don’t react fast enough to the onset of inflation, then overtighten monetary policy, which causes a crisis and the threat of deflation, which central banks respond to with excessively loose monetary policy. Then the cycle repeats. This implies we’re in for a deflationary shock, perhaps imminently, as central bankers overtighten again.

The inflationary argument is that PPIs are only part of the story. Plenty of other issues matter to inflation. And some of them are signalling inflation is here to stay. Wages and unionisation, government spending as a percent of GDP, debt that must be inflated away and central bankers’ commitment to rescuing government deficits when they get out of control, for example.

So, here’s how I see it, on balance. The probabilities are shifting towards the two extreme outcomes. Either central banks will lose control of inflation or they will cause a deflationary shock similar to 2008.

Just as the US housing bubble of 2006 led to this shock, government debt and deficits are driving the same truth today. Central banks face a choice between two divergent outcomes. They can cause a crash to prevent inflation or they can let inflation run because they need to keep the government funded.

Historically speaking, this choice is nothing new. And central bankers have almost always chosen the inflationary path…eventually.

Regards,

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend