Global Economy – Inflation, Deflation Debate

Economies with low interest rates in order to fight the current economic environment would gravitate towards inflation while some other nations with overhang of bad debt would create deflation, as suffered by Japan over the past two decades.

The dominant theme that is overriding other issues at gatherings at both central bankers and other players in the global economy is the debate over the inflation versus deflation triggered by higher commodity prices. Since the Great Depression, there has been a long-lasting debate on how best to battle recessions and deflation. Over the past couple of decades, policy makers have to rely on monetary policy as a panacea for all economic ills. Cutting interest rates has become a magic stick for any kind of economies woes, be it a financial meltdown, the economic aftermath of a terrorist attack or the costs of a war. However, experts believe this is unrealistic and dangerous, and causes bubbles.

Prima facie, economies with low interest rates to fight the current economic environment would gravitate towards inflation while some other nations with overhang of bad debt would create deflation, as suffered by Japan over the past two decades. If we go by these two dichotomies, the debate is still alive and kicking.

Is the global economy going to suffer a toxic combination of both inflation and deflation? The answer is, nobody knows which of these two scenarios will ultimately exist. Most possible outcome is a high probability of both, starting with inflation which will lead to deflation and then into deeper and more uncontrolled inflation. Thus the debate of inflation and deflation has important implications for investors who have no option but to be diversified and protected to some degree against both.

Blame it on crude oil

History reveals that once oil has surged, prices tend to come down again in one of two ways. Either there is a financial collapse, as took place in 2008, or a lengthy and painful economic slump which gradually squeezes down demand, as happened after the oil jumps of 1973 and 1980. Apparently, oil is now less central to the global economy as the global oil bill currently amounts to 4.2% of gross domestic product (GDP). On this basis, analysts say West Texas Intermediate crude would need to get to $136 to produce a shock equal to the last one, and to $200 to equal the damage done in 1980. It reached $100 in third week of March 2011. However, if oil prices rise further from the current level $120 per barrel, it would plainly be damaging the global economy.

With the emerging economies recovering rapidly from the post-Lehman recession of 2009, demand for industrial metals and agricultural products have risen far faster than supply can rise. On the other hand, hedge fund speculators and retail investors expending exchange-traded funds (ETF) to cash commodities boom which may lead to bubbles.  Nevertheless, widening supply and demand of commodities alone have been enough to ensure higher prices.

Loose Monetary Policy 

The US Federal Reserve announced another round of quantitative easing (QE2) to inject $600 billion of funds into the economy, to keep interest rates low, encourage consumers to spend and ultimately to stimulate economic growth. The quantitative easing is essentially amounts to printing money to buy US Treasuries. However, the Fed came in for severe criticism by world leaders, especially from emerging markets as its policies were causing inflation and pushing down the US dollar. According to them, the Fed’s loose monetary was having on global inflationary risks and asset prices. However, Fed chairman Ben Bernanke was unrepentant and consider that emerging economies should, among other things, allow their currencies to increase in value as a way to control such issues.

Both emerging economies and the US economies are blaming each other about their policies. Many high-profile economists and critics argued that the very low interest rates will cause inflation, while others regard deflation (prices and wages falling across the board) as a bigger threat. Deflation is a significant risk, especially for the economies with high debt levels, as it may lead to falling demand, falling prices and lackluster economic growth. In the US, total debt is close to 400% of GDP. Even in many Western economies, not only government but even private sector debt levels are so high, therefore these risks cannot be ignored. Against this backdrop, economic growth in these countries could continue to be weak at least for some time as households, firms and governments defer consumption and use free cash to pay down debt. Economist anticipates that this process of deleveraging could take a long time and lead to low growth and deflation.

The Case for Deflation 

Market watchers champion both sides of the debate despite Ben Bernanke's best efforts to flood the financial system with liquidity. Shedlock, an investment advisor with SitkaPacific Capital and author of the economics blog, MISH'S Global Economic Trend Analysis, made the case for deflation. He is of the view that "The money supply is just sitting there as excess reserves on bank balance sheets. Bernanke can print this money but unless it makes its way into the real economy we're not going to see inflation." Mish predicts "another leg down" in housing and commercial real estate, more consumer loan defaults, and notes state and local governments are (finally) cutting back on spending in the face of falling tax receipts and budget deficits.” According to him, all these trends will contribute to the deflationary force of credit contraction.

However, Marc Faber, publisher of the Gloom, Boom and Doom Report, says, “When the economy's bad, governments pile up these fiscal deficits and they print money" to offset the deleveraging of the private sector.” If governments are going to print paper currency endlessly for more stimulus packages, it will lead to bankrupt western governments - not just the US but everywhere.