The Tug of War Between Inflation and Deflation
In the US economy, there is a tug of war between inflation and deflation — and it only appears stable. This presents a conundrum most economists do not understand, and that the Fed and White House definitely do not understand. They are working with outdated or simply flawed models that say money printing leads to inflation and deficit spending is stimulative. Both assumptions are wrong.
What is happening is that certain inflationary forces (money printing and deficit spending) are in a struggle with certain deflationary forces (demographics, technology, high debt loads, and precautionary savings).
I explained this conundrum 10 years ago in my first book, Currency Wars:
‘The Fed is attempting to inflate asset prices, commodity prices and consumer prices to offset the natural deflation that follows a crash. It is basically engaged in a game of tug-of-war against the deflation that normally accompanies a depression. As in a typical tug-of-war, not much happens at first. The teams are evenly matched and there is no motion for a while, just lots of tension on the rope. Eventually one side will collapse, and the other side will drag the losers over the line to claim victory. This is the essence of the Fed’s gamble. It must cause inflation before deflation prevails; it must win the tug-of-war.’
Two critical concepts
This quote illustrates two critical concepts. The first is that a tame time series of inflation indices does not mean that we are in a stable equilibrium. In fact, the system is highly unstable, but the forces of inflation and deflation are fighting each other to a tie for the time being. The point of the tug-of-war analogy is to illustrate a situation in which the rope (inflation/deflation) is not moving but the stress (in opposite directions) is enormous. This will not last.
The other concept is that not much has changed in 10 years. The description above was written in 2011 but could have been written yesterday and would still be entirely accurate. The world wants to deflate. Central banks cannot have deflation, so they print money promiscuously. Neither side wins in the short run, although prices appear stable. Yet we are moving closer to the point where one side collapses, the other side prevails, and either inflation or deflation dominate.
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Which side wins the tug of war?
Inflation will be subdued in the short run, not only by the fundamental deflationary offsets described, but by onerous Biden administration policies, including shutting down oil and gas development, higher taxes, more regulation, open borders bringing in low wage workers, a higher minimum wage (which destroys existing jobs and is ignored by illegal immigrants), and the Green New Deal, which will result in higher energy costs.
None of this means that inflation is dead. It’s only sleeping. After 2021, we may experience the highest rates of inflation since the 1970s and that inflation may persist for decades. The reason why brings us finally to the real environment that determines economic conditions and has nothing to do with short-term data, Fed policy, or conventional economic models. These are mere content. To grasp this all-encompassing environment, we must view the world as a single market, with a single rate of return and a single dominant price trend.
The idea of a single rate of return seems strange at first. Today, the benchmark 10-year Treasury note has a yield-to-maturity of 1.633%. The comparable benchmark bond in Germany yields -0.337%, the UK benchmark yields 0.765%, and the Chinese benchmark bond yields 3.258%. That’s more than a 3.5% spread from high to low.
Yet these interest rates are all linked by factors including inflation, growth rates, and exchange rates. This is the result of what economist Robert Mundell called…
Mundell identified three critical policy variables: The central bank policy interest rate, the exchange rate, and open capital accounts. He said that nations could control any two of these variables, but not all three at once.
The major economies today all have mostly open capital accounts (although China does impose some restrictions), which means they can control interest rates or exchange rates, but not both. Most major economies fix interest rates, which means they lose control over exchange rates.
This means the interest rate and exchange rate have to be thought of as a pair. A higher interest rate generally results in a stronger currency.
Guestimating isn’t good enough
The ability of central banks to pursue any interest rate policy they might prefer is further constrained by conditions in the real economy. Central banks target policy rates intended to produce maximum real growth, low unemployment, and price stability.
If the Fed guesses at a natural rate that is too high, it will slow the economy, hurt job growth, and cause disinflation or deflation. If the Fed guesses at a natural rate that is too low, it will cause the economy to run hot, tighten labour markets, and cause inflation. Since the Fed is guessing, it is likely to guess wrong. Sooner rather than later, the Fed’s incorrect guess shows up in economic data.
Still, the result of trying to hit a neutral rate means central banks will wander high or low while trying to converge on the unseen target. Other central banks are doing the same. This natural rate targeting, combined with Mundell’s trilemma, shows us that all major central banks with reserve currency status are not really free agents but are highly constrained by the need to hit the neutral rate, avoid inflation or deflation, and maintain reasonably stable exchange rates. This is a highly imperfect process with many errors committed along the way, but it does provide a framework for forecasting international monetary policy using just a few key factors.
I’ll explain more in a future edition of the DR — stay tuned.
Strategist, The Daily Reckoning Australia
PS: This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.