• The conventional view held by most economists and market commentators is that the rate of inflation falls in a recession. In this week’s post we will challenge the conventional view and discuss the circumstances that could lead to accelerating rates of inflation during a period of recession.

• At the end of this article, we will discuss why inflation, not deflation, might be the surprise outcome of the next recession in the United States.

• Intuitively, the notion that inflation falls during a recession seems quite reasonable. After all, the first lesson we learn in microeconomics is that if demand for a good weakens, then the price of that good will fall. So why not extrapolate this idea to macroeconomics? Why can’t we simply assume that inflation will slow if the economy begins to contract?

• The problem is that a microeconomic level, basic supply and demand analysis assumes that the market value of money is constant. At a macroeconomic level, we simply can not make this assumption. Rather, we need to think about the impact a recession has on expectations regarding the long-term future of society and how changes in those expectations impact the value of money.

• In a recession there are two opposing forces that act upon the price level, one is deflationary in nature, the other is inflationary.

• The deflationary force is the impact of the recession on aggregate demand and the resultant fall in the market value of goods.

• Note the use of the term “market value”, not “price”. The price level is a relative measure of market value: just because the market value of the basket of goods falls does not mean that the price of the basket of goods falls.

• The inflationary force is the potential negative impact of the recession on long-term expectations and, consequently, a fall in the market value of money.

• Typically, a recession is accompanied by some moderation in expectations regarding the long-term economic future of society. If people become more pessimistic about the long-term prospects of society, then the market value of money will fall and, all else remaining equal, the price level will rise.

• While the nature of the deflationary force is simple and obvious, the nature of the inflationary force is far more nuanced and complex. The final outcome in a recession depends upon whether the deflationary force is stronger or weaker than the inflationary force.

• If the deflationary force is stronger (if the market value of goods falls by more than the market value of money) then the rate of inflation will moderate. For example, if people believe that the recession is just a “bump in the road” that won’t damage the economy over the long term, then it is likely that the rate of inflation will fall.

• However, if a recession badly damages confidence in the long-term prospects of society, then any decline in the market value of goods can be more than offset by a decline in the market value of money. In this scenario, the rate of inflation can accelerate markedly, particularly as economic activity begins to stabilize at lower levels.

The Price Level is a Relative Measure of Market Value

Before we begin to discuss how a recession may impact the rate of inflation, we need to step back and think about the nature of the price level.

While most of us think of the price level as an index (the consumer price index), strictly speaking the price level is a conceptual notion, not an index. More specifically, the price level is a hypothetical measure of overall prices for the set of goods and services that comprise the “basket of goods”.

At a more fundamental level, the price level is a relative measure of market value. The price level measures the market value of the basket of goods in terms of the market value of money.

From a mathematical perspective, if we can measure the property of “market value” in terms of a standard unit of market value (a unit of measure that is invariable in the property of market value), then the price level can be expressed as a ratio of two market values. More specifically, the price level is a ratio of the market value of the basket of goods (the numerator) divided by the market value of money (the denominator).

In simple terms, the price level can rise either because (a) the market value of goods rises, or (b) the market value of money falls.

This theory is discussed in a recent post titled “Ratio Theory of the Price Level”. While we won’t discuss this theory at length, we should briefly touch on the keys points.

The derivation of Ratio Theory begins with the microeconomic premise that every price is a relative expression of market value.

For example, if one apple is twice as valuable as one dollar, then what is the price of apples? Clearly, the price is two dollars. The point is that the “price of apples” is a relative measure of the market value of one apple versus the market value of one dollar.

What happens to the price of apples if the value of money falls? For example, what would be the price of apples if, all else remaining equal, the dollar lost 50% of its value? One apple would now be four times more valuable than one dollar. Therefore, the price of apples would be four dollars. i.e. the price of apples would double.

In more general terms, the price of one good (the “primary good”) in terms of another good (the “measurement good”) is a relative measure of the market value of the primary good in terms of the market value of the measurement good. The price of the primary good can rise either because (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

In order to understand this concept at a more technical level, one must be able to appreciate the difference between the relative and absolute measurement of market value. This is a somewhat complicated idea that is addressed in detail in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”.

We can extend this microeconomic theory of price determination to a macroeconomic level (“Ratio Theory of the Price Level”) by recognizing that the market value of money is the denominator of every “money price” in the economy.

The price level is merely a measure of overall prices for a basket of goods: roughly speaking, it is an “average” of prices. If money is the “measurement good” in our economy, then the market value of money is the denominator of each “money price” in our economy. Moreover, if every price in the basket of goods shares a common denominator (the market value of money), then this common denominator is also the denominator of the average of these prices (the price level).

Ratio Theory provides us with a useful starting point for any discussion regarding the inflationary or deflationary impact of a change in economic conditions. Most importantly, it reminds us that we need to consider the impact of a change in economic conditions on both the market value of goods and the market value of money.

We can illustrate Ratio Theory with the “Goods-Money Framework” that is developed in The Inflation Enigma, the second paper in The Enigma Series. On the left hand side, the intersection of aggregate supply and aggregate demand determines the equilibrium market value of the basket of goods, denoted “V_G”. On the right hand side, supply and demand for money determines the market value of money, denoted “V_M”.

Again, the key to the Goods-Money Framework is that market value, on the y-axis of both charts, is measured in absolute terms, that is to say, in terms of a “standard unit” for the measurement of market value.

With this basic framework in mind, let’s think about how a recession may impact the price level.

For the purposes of this post, we shall assume that a recession leads to a decline in the market value of goods, the numerator in our price level equation.

In terms of the Goods-Money Framework illustrated above, a recession pushes the aggregate demand curve to the left and the market value of the basket of goods V_G falls.

We could argue about whether this is always the case. For example, an oil price shock may lead to a rise in the market value of the basket of goods as tightness in the oil market pushes the aggregate supply curve to the right. But for the purpose of this exercise, it is reasonable to assume that a recession leads to a fall in aggregate demand that, in turn, that leads to a fall in the market value of the basket of goods.

The question we need to ask now is what happens on the right hand side of our Goods-Money Framework? Does a recession have any impact on the market value of money, the denominator in the Ratio Theory equation?

The Impact of a Recession on the Market Value of Money

In order to understand the potential impact of a recession on the market value of money, we need to understand both why money has value and what factors influence the value of money. These are topics that we have discussed at length in recent posts including “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

The view of The Money Enigma is that fiat money has value because it is a liability of society. More specifically, fiat money represents a proportional claim on the future output of society. 

The key implication of this theory is that the value of fiat money depends upon confidence in the long-term economic future of society.

When people are confident in society’s long-term economic prospects, the value of the fiat money issued by that society is well supported. However, when people lose faith in the long-term economic future of their society, the value of money falls.

In simple terms, fiat money is only as good as the society that issues it.

Fiat money represents a claim against our collective economic wellbeing. If people begin to doubt the long-term future of their society, then the value of a claim against that future, i.e. the value of fiat money, will fall.

Fortunately, expectations regarding the long-term future of society tend to be relatively stable over time. As a result, the value of fiat money tends to be relatively stable over time.

Nevertheless, confidence in the long-term future of society can erode suddenly, particularly if structural economic problems have been quietly accumulating over a long period of time.

A severe recession is one event that may lead to a sudden decline in confidence regarding the long-term economic future society and, consequently, a sudden decline in the market value of money.

While economists might debate the cause of the economic cycles, most of us are accustomed to the idea that the economy moves in cycles. Therefore, an economic recession may create a period of uncertainty, but in most cases, people will remain relatively confident in the long-term economic prospects of society. Indeed, if there has been an economic boom, particularly in one sector of the economy (technology in late 1990s), then many people may feel as though the recession that follows that boom is just “business as usual”.

The point is that a recession does not, prima facie, lead to a collapse in confidence regarding the long-term prospects of society.

However, a recession can expose serious structural problems that have been accumulating. Moreover, recessions tend to become a “test of faith” in the sense that they test the market’s confidence regarding the ability of policy makers to steer the economy back on to the right path.

For example, in the last recession (the “Great Recession” of 2008/2009), several structural issues were exposed. Most notably, markets suddenly became aware of the relatively poor fiscal position of the United States. Government debt suddenly surged from 65% of GDP to 90% of GDP as the federal government began to run deficits in excess of $1 trillion a year. Moreover, concerns began to resurface regarding the long-term sustainability of key entitlement programs such as Social Security and Medicare.

However, for most people, these concerns were offset by confidence that policy makers, most notably the Federal Reserve, could steer the economy in the right direction. Indeed, since the Federal Reserve embarked on its program of quantitative easing, confidence in the long-term prospects of the United States have improved markedly as measured from the low point in confidence that occurred in about 2010/2011, the same time the price of gold peaked.

On this occasion, a recession did not significantly damage confidence in the long-term prospects of the United States. Consequently, the market value of money (the US Dollar) did not decline significantly and inflation remained subdued.

Nevertheless, every recession represents a test of confidence. If a recession severely damages long-term confidence, then the market value of money can fall sharply, more than offsetting a decline in the market value of goods. If this scenario, inflation will accelerate.

Ultimately, the view of The Money Enigma is that there is a simple rule of thumb in regards to the relationship between inflation and recession.

If a recession does not significantly impact long-term confidence in the economic future of society, then the rate of inflation will probably fall during the recession. However, if a recession does badly damage long-term confidence, then the value of money will decline sharply and the rate of inflation is likely to accelerate.

If this theory is correct, then what implications does it have for the next recession in the United States? Should we expect the next recession to result in a period of outright deflation? Or will the next recession see an acceleration of the currently subdued rate of inflation?

Will the Rate of Inflation Accelerate in the Next Recession?

If you did a quick survey of market commentators and asked them whether inflation would rise or fall in the next recession, I suspect that nearly 90% of respondents would say that inflation would fall.

This worldview has been reinforced not only by the experience of the past thirty years but also by memories of the Great Depression.

So, let’s play devil’s advocate and think about why this may not be the case when the next recession hits.

First, it is worth noting that the Great Depression should not be used as a guide for how the prices will behave in a recession, even a severe recession, under a fiat currency system. The reason for this is simple. During the Great Depression, the market value of money was fixed. More specifically, the market value of money (the US Dollar) was fixed to the market value of gold.

Therefore, when the Great Depression hit, the market value of money (the denominator in our price level equation) was relatively constant, even as the market value of goods (the numerator in our price level equation) declined dramatically.

This will not happen under our present fiat regime. Rather, under our present system, the value of money fluctuates depending upon confidence in the long-term prospects of society. If an event of the scale of the Great Depression was to occur again, then it is likely that the value of money in our present fiat system would collapse, more than offsetting the decline in the market value of goods.

Second, if we think about the experience of the last thirty years, none of the recessions during that period (1990, 2001, 2008) badly dented confidence in the long-term prospects of the United States. As discussed, the 2008 recession came the closest to challenging the consensus view on this issue, but in each case, long-term confidence was not badly damaged and the value of money was not significantly impacted.

So, what will happen to long-term confidence and, consequently, the value of money in the next recession?

Clearly, we can not say for certain. However, we can speculate on issues that might arise should a recession occur in the next few months.

First, it is likely that some of the structural problems that were exposed in the last recession will become issues of greater concern in the next recession.

The US government has made no progress in reducing government debt as a percentage of GDP (government debt now stands at over 100% of GDP versus only 65% at the beginning of the last recession).

Perhaps more importantly, the US government has made no progress on entitlement reform. Indeed, the CBO projects that fiscal deficits will climb as a percentage of GDP over the next twenty years, even if the US economy continues to grow at a reasonable pace.

While these structural issues remain largely unresolved, the view of The Money Enigma is that the bigger test during the next recession will be the markets confidence in the ability of policy makers to stabilize the economy.

Consider what would happen if the US economy entered recession today.

What would be the likely response from the Federal Reserve? Short-term interest rates are already at zero. Moreover, the Fed has made no attempt to unwind the monetary base that has quintupled since the last recession began.

The likely response from the Federal Reserve would be to embark on a new program of quantitative easing, thereby expanding the monetary base from its already unprecedented level. But would this next round of quantitative easing have the same impact as previous rounds? The law of diminishing marginal returns would suggest that it probably wouldn’t.

If the markets begin to feel that Congress and the Federal Reserve have lost control of the situation, then confidence regarding the long-term prospects of the United States could decline sharply. If this were to occur, then it is likely that the value of money would decline sharply, leading to a sudden rise in all prices as expressed in money terms and an acceleration in the rate of inflation.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com