Could 2015 be the year the markets experience both a “deflation scare” and an “inflation scare”?
The recent collapse of crude oil prices below $60 per barrel, combined with additional signs of global economic weakness, have renewed fears about an outbreak of deflation in the United States. Six years have passed since the US Federal Reserve first embarked on its current path of quantitative easing. The US Federal Reserve’s balance sheet has increased five-fold and other global central banks have followed in their footsteps. Despite this remarkable growth in the global monetary base, inflation has remained subdued.
The view of many in financial markets is that global deflationary forces are just too strong and that global central banks are increasingly impotent in their battle against deflation. This also seems to the view of at least one dissenter at the US Federal Reserve, Fed “dove” and Minneapolis Federal Reserve Bank President, Narayana Kocherlatkota, who argued that the Fed should be willing to further expand the monetary base if inflation continues running below the Fed’s 2% target.
While it may not be explicitly acknowledged by those who hold these deflationary expectations, this represents a quintessentially “Old Keynesian” perspective regarding the way the world operates. In essence, it is the view that if aggregate demand is weak, then prices must fall. Moreover, if global competition is pushing the aggregate supply curve to the right, then this only compounds the deflationary pressures.
The problem with this view is that it represents a very “one-sided” perspective on how “money prices” are determined in our economy. While it is true that well-entrenched deflationary forces (i.e., falling oil prices, global economic stagnation, and increasing global competition) have, and will probably continue to, put downward pressure on the value of global goods and services, there is a key element that is missing from our analysis: the future path of the value of money.
The value of money is the denominator of every “money price” in the economy. Every money-based transaction involves an exchange of two items of value. When you buy your morning cup of coffee, you receive one good of value and, in exchange, offer another good of value in return. This is the simple principle of all economic transactions dating all the way back to the barter economy of our ancestors. In our modern money-based society, the good of value that you offer in exchange for your morning cup of coffee is money.
The price of your morning coffee can rise for one of two basic reasons: the value of a cup of coffee can rise, or the value of money can fall. If the value of money falls, then, all else remaining equal, your local coffee shop will require you to give them more dollars for that morning cup of coffee.
We can extend this simple concept to the price level and changes in the price level (inflation). The value of money is the denominator of every “money price” in the economy and therefore the denominator of the price level. As the value of money falls, the price level rises.
In simple terms, this is the “Ratio Theory of the Price Level”, an economic theory of price level determination developed in The Enigma Series. Ratio Theory suggests that any “inflation versus deflation” debate needs to begin with a simple equation. Mathematically, the price level “p” can be described as a function of the value of goods and services “VG” and the value of money “VM” (see image below).
Inflation can be thought of as a game of “tug-of-war” between these two opponents. Currently, the world is experiencing strong deflationary forces that are placing downward pressure on the numerator in our equation, the value of goods and services. The current fall in oil prices should only accentuate these forces.
The bigger question relates to the future path of the value of money? The value of money has been relatively stable over the past few years, despite the massive expansion in the monetary base. However, is it reasonable to expect this stability to continue? And if the value of money does fall, then will it overwhelm the steady decline in the value of goods and services? In other words, will the denominator in our equation fall by more than our numerator?
You may ask why economics doesn’t present the “inflation/deflation” debate in these simple terms. Mainstream economics struggles with the concept outlined above because it does not recognize “the value of money” as a variable in its equations. In technical terms, economists struggle with the notion that price is a relative expression of two market values (the market value of a primary good as expressed in terms of the market value of a measurement good). Moreover, economics has largely failed to recognize that the property of “market value” can be thought of in both “absolute” and “relative” terms.
But before we get carried away with economic theory, let’s return to the topic at hand. What is the inflation outlook for 2015?
It seems reasonable to believe that the current weakness in the oil price, should it be sustained, will have some flow through effects over the course of the first few months of 2015. Energy costs represent a significant input cost for many industries and lower oil prices should contain any inflation over the next few months.
However, it seems unlikely that deflation represents the greatest risk to investors in the second half of 2015. Rather, the greatest risk to long-term investors remains a sudden collapse in the value of money and a significant jump in the rate of inflation. Indeed, 2015 may be remembered as a “flip-flop” year: fears of deflation in the first-half of the year rapidly switch to fears of inflation in the second-half of the year.
So, what is the risk of a sudden collapse in the value of money in 2015?
After six years of experimentation with the monetary base, many investors have been lulled into a false sense of security regarding this issue. The view of some investors is that if QE was going to negatively impact the value of the US Dollar, then it would have already happened by now. However, this is a naïve and simplistic view.
Ultimately, the value of a fiat currency is a function of the confidence that markets have in the long-term economic prospects of the society that issued it. More specifically, the value of money reflects expectations regarding the long-term path of the “output/money” ratio.
Over the past few years, markets have become more optimistic regarding the long-term prospects for the US economy. The view is that the US economy will continue to grow strongly over the next 10-20 years, even as the monetary base is “normalized” from its current extended levels.
However, if confidence in this view is shaken, then the value of the US Dollar will come under pressure. For example, if the Fed does reduce the monetary base, even modestly, and this results in a recession in the US, then investors’ long-term confidence in the path of the “output/money” ratio could be quickly shaken. The question for all investors is whether 2015 is the year that confidence turns.
Clearly, the role of expectations in the determination of the value of money and the price level is a complicated matter and future articles will be dedicated to exploring this issue further.
So, is deflation or inflation a greater risk in 2015? Near term, the risks may be on the side of deflation. But longer term, the risks are squarely in the inflation camp.