• Is inflation or deflation the greater risk in 2016? Is it possible for inflation in the United States to accelerate in the midst of global economic weakness? And in a world of complex economic cross currents and unpredictable policy actions, how do you even begin to answer these questions?

• Most market commentators overly simplify the inflation or deflation debate by making a false assumption, namely that “economic weakness = deflation” and that “economic strength = inflation”. This represents an essentially Keynesian view of the world, a view that dominates the thought process of most central bankers.

• But is it really this simple? Will the inflation outcome in 2016 be determined solely by the strength of the US economy? Or is there another factor at play? A factor that is harder to observe and quantify, yet one that could have a much greater impact on the 2016 inflationary outcome than near-term economic conditions?

• The view of The Money Enigma is that we can break any analysis of inflation in two parts. First, we need to consider how near-term economic conditions might impact the market value of goods. For example, if the economy deteriorates, then we need to think about how this might negatively impact the value of goods and labor. This is the traditional part of the analysis that is familiar to most commentators.

• The second part of the analysis is less orthodox and requires us to consider how expectations regarding the long-term economic prospects of society might shift and how any such shift might impact the market value of money.

• A shift in long-term expectations is the critical second factor that is often ignored by market commentators. Long-term economic expectations play a critical role in the determination of the market value of money. More specifically, if people lose faith in the long-term economic prospects of society, then this undermines the value of fiat money issued by that society.

• In this week’s post, we will explore what might happen if this second, often silent, factor comes into play in 2016. More specifically, it will be argued that inflation could accelerate markedly in 2016 if long-term confidence is damaged.

• Ironically, the global economic weakness that many believe will drive a deflationary outcome in the United States in 2016 could be precisely the factor responsible for triggering a decline in long-term economic confidence and a reacceleration in the rate of inflation.

The Risk of Inflation: A Two-Part Analysis

Any attempt to analyze the risk of inflation assumes, prima facie, that one understands the key drivers of inflation. Unfortunately, economists have been unable to reach consensus regarding the primary causes of inflation.

In very rough terms, there are three competing views regarding the primary cause of inflation. Keynesians believe that inflation is caused by “too much demand” relative to the economic potential of the economy. Monetarists believe that inflation is caused by “too much money” relative to real output. Fiscal Theorists believe that inflation, particularly severe inflation, is caused by “too much government debt” as measured relative to GDP.

Professor John Cochrane in his article “Inflation and Debt” does a much better job than I can of describing these various schools of thought and some of the problems associated with each.

While each school of thought has its own problems, the greater issue from my perspective is that each school of thought speaks a different language. More specifically, the basic price level models used by the various schools of thought don’t really talk to each other. For example, the New Keynesian expectations-augmented Philips Curve doesn’t explicitly include a role for government debt and, quite frankly, has almost completely excluded any explicit role for the size of the monetary base (in the New Keynesian world, money only matters if it impacts the interest rate).

So, in the midst of all this academic confusion, how does one begin to analyze the outlook for inflation?

The view of The Money Enigma is that we can simplify our starting point by recognizing a fundamental truth: the price level is a relative measure of market value. More specifically, the price level is a relative measure of the market value of the basket of goods in terms of the market value of money.

Mathematically, the price level can be expressed as a ratio of two values. The price level is determined by the ratio of the market value of goods V_G divided by the market value of money V_M. The key to demonstrating this is recognizing that the property of market value can be measured in absolute terms, i.e. in terms of a “standard unit” for the measurement of market value. Both the market value of goods V_G and the market value of money V_M in the equation above are measured in terms of this standard unit. You can read more about this very important concept in “The Measurement of Market Value: Absolute, Relative and Real”.

If the price level is a relative measure of two factors (the market value of goods and the market value of money), then this automatically suggests that any analysis of inflation needs to be conducted in two parts.

First, we need to consider the impact of near-term economic conditions on the market value of goods, the numerator in our price level equation. Second, we need to consider how shifts in long-term expectations might impact the market value of money, the denominator in our price level equation.

As you will see from the analysis that follows, we can use this simple two-part framework (“Ratio Theory of the Price Level”) to incorporate many of the ideas that are promoted by the various schools of economic thought. More specifically, we will explore how aspects of Keynesianism, Monetarism and Fiscal Theory can all be incorporated into a discussion of the outlook for inflation.

On that note, let’s begin our two-part analysis of the outlook for inflation in 2016.

2016 Inflation Outlook, Part One: Will Global Economic Weakness Put Pressure on the Value of Goods & Labor?

There can be no question that, over the past couple of decades, major global deflationary forces that are secular in nature have emerged and that these forces have played a key role in creating the low inflation environment that is currently being experienced in the Western World.

The opening of major European markets at the end of the Cold War, the free market revolution in China and the emergence and mass adoption of the Internet have all contributed to a more competitive world.

Moreover, none of these deflationary forces look set to reverse, at least not in the near-term. Despite political tensions between Russia and the US, it seems very unlikely that the USSR will return. In China, economic bumps all the road have been met with some unorthodox policy, but the fundamental trend towards free markets still seems to be firmly in place. As for the Internet, it is hard to imagine a world without it, despite that the fact that many of us, myself included, began our careers before email existed!

Therefore, it seems relatively safe to assume that we can extrapolate these secular trends forward for at least another decade.

The secular trends may be clear, but what about the impact of cyclical factors? Are we safe to assume that, in the near term, cyclical factors will also add to the deflationary pressures?

This is a more difficult call because it requires us to see ahead into economic conditions in 2016. Will the US economy slow further in 2016? Will China act as an anchor on global economic growth in 2016?

Frankly, many of you will be in a better position than me to answer these questions. Nevertheless, let’s assume, for the sake of argument, that economic weakness spreads further in 2016 and that the US economy slows down markedly. What would we expect the impact to be on the value of goods and labor?

Clearly, any US economic weakness in 2016 would put further downward pressure on the market value of the basket of goods, the numerator in our price level equation.

This part of the analysis is entirely consistent with the Keynesian view. If secular forces continue to drive growth in aggregate supply and these secular forces are met by a cyclical decline in aggregate demand, then we should expect an increase in slack in the economy and downward pressure to build on both the value of goods and labor.

So, is that the end of our analysis? Absolutely not.

Many market commentators (and central bankers) might stop their analysis at this point and conclude with the observation that “if the economy is weak in 2016, then the risk of deflation is greater than the risk of inflation”.

The problem with concluding our analysis at this point is that we have only considered half of the picture. Inflation is not simply a function of economic strength. If it were, then Zimbabwe would have experienced deflation as its economy imploded, not hyperinflation.

So, what is the missing link? Why is it possible for economic decline to be met with an acceleration in inflation? The answer lies in the denominator of our price level equation: the value of money.

2016 Inflation Outlook, Part Two: Will a Decline in Long-Term Economic Confidence Trigger a Sharp Decline in the Value of Money?

In order for money to be accepted in exchange, money must possess the property of market value. In a commercial exchange, you are not going to give me something of value (for example, an apple) unless I give you something of value in return. When I pay for the apple with money, you accept money because you believe that money has value, value that will be recognized the next time you try to use the money I gave you to buy something.

The value of money has a critical role to play in the determination of prices as expressed in money terms. In simple terms, if the apple I try to buy from you is worth twice as much as one dollar, then I will have to give you two dollars to pay for it. If the value of money falls relative to the value of the apple, then I will have to give you more dollars for the apple, i.e. the price of the apple in money terms rises.

We can extrapolate this simple principle to the price level. The price level is a measure of the market value of the basket of goods in terms of the market value of money. In other words, all else remaining equal, if the value of money falls, then the price level rises.

This raises an obvious question: what determines the value of money?

The answer to this question is far from obvious and is something that still eludes the science of economics. Indeed, most economists struggle to even acknowledge the “market value of money” as an independent variable, for reasons that are discussed at length in a recent post titled “The Value of Money: Is Economics Missing a Variable?”

Nevertheless, by observing the history of various fiat currencies, we can make one sweeping observation regarding the nature of fiat money: fiat money is only as good as the society that issues it.

In more specific terms, the value of fiat money depends upon confidence in the long-term economic prospects of the society that issued it.

If confidence in the future of society is strong, then the value of the currency issued by that society should be well supported. Conversely, if confidence in society’s future deteriorates, then the fiat money issued by that society will decline in value. In an extreme situation, if confidence in the economic functioning of a society collapses, the value of the fiat currency issued by that society will collapse, triggering a period of hyperinflation.

Intuitively, it makes sense that the value of the fiat money issued by our society should be intimately tied expectations regarding the economic future of our society. However, from a theoretical standpoint, explaining why this is the case is a complicated challenge.

The view of The Money Enigma is that the value of fiat money is tied to confidence in the economic future of society because fiat money represents a proportional claim on the future output of society.

Fiat money is a financial instrument: it derives its value from its implied contractual properties. Fiat money is a liability of society and a claim against the future output of society. More specifically, fiat money is a long-duration, special-form equity instrument and represents a proportional claim against the future output of society.

This theory of money, “Proportional Claim Theory”, is discussed at length in the “Theory of Money” section of this website.

From a practical perspective, the primary implication of this theory is that the value of fiat money depends upon market expectations regarding the long-term (30 year+) future path of two key variables: real output and the monetary base.

Currently, the market is optimistic regarding the long-term path of real output relative to the monetary base. Most commentators believe that the Federal Reserve will reduce the monetary base from its current extended levels over the next 10 years and that during that time real output will continue to grow at solid rates.

This combination of optimistic expectations has supported the value of the US dollar and, as a result, has helped keep a lid on prices.

The fact that the Fed has quintupled the monetary base over the past seven years has had little negative impact on the value of money because the market perceives this monetary expansion to be “temporary” in nature.

But what happens if confidence in the long-term economic future of the United States declines and the market begins to believe that the Fed’s program of quantitative easing is more “permanent” in nature? What happens if global events unravel such that the market begins to believe that the Fed won’t or can’t reduce the monetary base?

Let’s continue with the 2016 scenario that we discussed in Part One: the global economy continues to weaken, with several major countries slipping into recession, and economic growth in the United States slows to crawl speed.

This is a scenario that most economists believe will almost certainly produce a deflationary or very low inflation outcome. I agree that such a scenario would put pressure on the market value of the basket of goods. But what might happen to the value of money in such a scenario?

Arguably, a period of global economic weakness in 2016 could become a tipping point for long-term expectations regarding the structural health of the United States.

Think about these factors.

First, as we enter 2016, the Fed will have made little to no progress in reducing the monetary base. Will a global recession encourage the Fed to accelerate a reduction in the monetary base? No. In an extreme scenario, a global economic recession may encourage the Fed to further expand the monetary base.

Second, a slowdown in the rate of growth in the US will not improve the Federal budget deficit nor help to reduce the outstanding debt of the US Government. Rather, a deterioration in near-term economic conditions is likely to fuel concerns about the long-term fiscal sustainability of the United States.

Third, the Fed has spent the last five years searching for “lift off”, the magic point at which the US economic recovery becomes strong and self-sustaining. After seven years of sub-par growth, a slowdown in US economic growth in 2016 might be the straw that breaks the camel’s back: the event that causes the market to lower its long-term expected growth rate for the US economy.

What is the likely outcome of the combination of these three factors: a sharp decline in the value of money.

If the theory of money discussed above is correct and fiat money represents a proportional claim in the future output of society, then a loss of confidence in the long-term economic future of the United States could easily lead to a sharp decline in the value of the US dollar.

2016: The Balance of Probabilities

What is the outlook for inflation in 2016? Our two-part analysis suggests that there could be two conflicting trends at play.

First, it seems reasonable to expect that there will be continuing downward pressure of the market value of the basket of goods, the numerator in our price level equation. All else remaining equal, this would suggest a deflationary environment in 2016.

However, the risk is “all else remaining equal” doesn’t hold in 2016. More specifically, the risk is that global economic malaise, Fed inaction and a general loss of long-term economic confidence triggers a decline the market value of money, the denominator in our price level equation.

The ultimate outcome will depend upon which force is stronger and, perhaps more critically, the timing of how events unfold.

If the economy is weak, but long-term confidence remains strong, then the majority of market commentators may prove to be right: 2016 may be a year in which inflation remains contained. However, if weakness in the economy damages long-term economic confidence, then 2016 could be the year that inflation reaccelerates.

Author: Gervaise Heddle