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September 1, 2020

Inflation V Deflation: What We Can Expect Moving Forward?

What is inflation and deflation and how do they materially affect our every day and our investments

With all the uncertainty and sensationalist headlines around at the moment, the global economy can appear confusing and unsettling.

Inflation and deflation are words that are being thrown around a lot and in this article, I wanted to delve in a little deeper and hopefully give you more of an understanding of what they mean and what we can expect moving forward.

If something is rare, then it tends to be of high value. It is a simple matter of supply and demand – the more people who want the same thing, the more people are willing to pay for it.

Adversely, if something is common, then demand will be lower. Take diamonds, for example. If they literally grew on trees, then they would be pretty worthless.

A similar principle applies to money. The more of it there is in circulation, the less valuable the currency will be. If a government were to print more money, then there would be more of it in circulation, and this would make it less valuable, this is known as inflation, and it would decrease the purchasing power of the currency.

There are also other factors behind inflation. For example, if oil were in short supply, then demand would increase, pushing up the price. The future impact of an increase in oil prices is an increase in goods and services which depend on it.

However, there are positives to inflation. It typically means that the supply of money is higher than the demand, and this means people have more to spend. Which, in turn, means that people will be purchasing more, and this is good for the economy.

Inflation does need to be managed, however, as there are potential downfalls that can have a significant negative impact. For example, if you have been saving over the years, inflation will mean that the value of everything you have saved will decrease.

Deflation Shock and Covid-19

Covid-19 has sent shockwaves through economies globally. Countless people have lost their jobs, and many more are being as careful as possible financially, this results in fewer people buying goods, which means that prices come down, this is deflation.

Deflation is a problem for several reasons. One of these is that many buyers will delay purchasing items as they wait to see how much prices will fall, this can end up in a vicious cycle as delays in spending result in further deflation.

Lower prices will also mean less spending overall, and this means less revenue for governments. It also increases the value of debt, and this will, in turn, mean that consumers and firms have less spending power.

The Solution?

Moving forward, governments will need to take action to help control deflation, get more money circulating, and get their economies headed in the right direction again. There are a handful of ways that they can achieve this.

Government Bonds

One potential solution for some governments is to issue government bonds. Issuing bonds means that citizens and businesses will give the government money with a promise of receiving interest on the amount in question. The full sum will also be returned when the bond matures.

Government bonds can be effective in giving the government more money to spend on things like infrastructure, which can, in turn, create more jobs, giving more people money to spend, thus providing the economy with a much-needed boost.

There are problems with this solution, especially in times like these. One of these is it relies upon money being given to the government that could otherwise be spent on purchases. Another is that the government will need to make large payouts when the bonds expire, this is often covered by synchronizing the expiry of bonds with the issue of new bonds, resulting in a perpetual cycle.

International Borrowing

If the money is not available domestically, then a government could look to overseas for financing, although this is usually only done by emerging economies. If spent right, international borrowing can help to give the economy a boost, justifying the cost of the loan. However, if the money is not spent productively, then the economy will not receive the planned stimulation, AND the borrower will still owe the money to the lender.

While this solution does come with its risks, it does have its advantages. One of these is that it puts new money into the economy without having to take it from their economy.

Quantitative Easing

Another potential solution is for the government to print more money. The central bank can simply create it, and then use this money to ‘buy’ government bonds.

They can then use this new money to pay for things like infrastructure projects, and this will release more money into the economy. Quantitative easing works similarly to issuing government bonds to people and business in a sense because it means the government is essentially ‘borrowing’ money to put back into the economy. It has one key difference; however, in that the money is not coming from the economy, it is trying to boost.

Instead, this is entirely new money, meaning no existing money has been taken from the economy. It also means that there are no loans to be repaid domestically or internationally.

Quantitative easing has been used in the past, albeit with some reluctance, this is because it was thought that pumping new money into the economy would cause inflation to spiral out of control. However, this turned out not to be the case. One reason for this is technological developments that helped to make the production of good and services more cost-efficient, and this help to keep prices down.

Modern Monetary Theory

Another potential solution is the modern monetary theory, which is very similar to quantitative easing but, again, with some key differences.

The modern monetary theory involves new money being created, but this time, it is not being ‘borrowed’ from the central bank. Instead, the government creates the money themselves so it can then be used for projects that will see the funds distributed into the economy.

Modern monetary theory is considered by many to be a reckless printing of new money that can cause inflation to spiral out of control. However, this is not necessarily the case because there are ways to control inflation with modern monetary theory. One of these is to manage how much the government is printing and spending. Another is to increase taxes to help remove money from circulation.

Moving Forward

The first two potential solutions are unlikely to be suitable in the coming months, and maybe even years, this is because there is not going to be much money domestically or internationally as economies worldwide are struggling. It is also far from ideal to be borrowing from an economy that needs money going the other way.

Instead, governments are likely to be looking at creating new money to help boost their economies. Which, in turn, means quantitative easing, modern monetary theory, or a combination of the two. While inflation can often be managed despite new money being pumped into the system, the sheer volume of money needed is going to make this difficult.

Therefore, we are likely to see some inflation, in addition to counterbalances like adjustments in interest rates, and taxation.

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Article by: Rory van den Berg