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Treading the line: Inflation vs. Deflation
Friday October 28, 2022 - Issue # 28
GM! It’s been a pretty decent week for BTC, ETH, and other cryptos from a price action perspective. Bitcoin has been able to hold $20k while we saw mega cap FAANG stocks get crushed — particularly Meta and Amazon who got pummeled due to worse than expected earnings. The relative strength of BTC and subsequently the rest of the crypto market has been pretty impressive. I think this strength is positively correlated to the narrative build up that the Fed is close to pivoting. Tweets like this have taken over my timeline:
This note should be short. I’ve been hearing a lot about deflation — not inflation — being the real concern for the Fed and other central banks, but honestly, I’m not sure I totally understood why. I’m going do my best to break down why deflation can be worse than inflation and why central bankers need to be very careful not to go too far as to tip the scale toward a deflationary spiral.
Apologies if this is too rudimentary but I’ll start with defining both terms.
Inflation: When the prices of goods and services increase across the entire economy, decreasing the purchasing power of consumers.
Deflation (opposite of inflation): When the prices of goods and services decrease across the entire economy, increasing the purchasing power of consumers.
At first glance, deflation sounds pretty great — you’re telling me that my steaks might return to “normal” prices at some point? Sign me up! This was about the extent I thought through deflation till 4 o’clock this morning.
The Fed is currently taking the position (after embarrassingly flip flopping on the whole “transitory” narrative) that inflation is here to stay and at seriously high levels that can only be defeated by a historically aggressive interest rate hike pace. Fed Chair Powell has stuck to his script and assured us at every chance he will keep going until inflation is on a clear path to the 2% target. He’s left no doubt that he’s willing to bring the pain in the short-term, to combat the potentially long-term ramifications of sustained high inflation.
I wouldn’t be surprised if Powell keeps his Volker Halloween costume on for the FOMC meeting next week.
Inflation is not fun, we are all feeling it one way or another which is why it’s such a pressing issue. But is it really worth throwing the economy into a potentially devastating recession for? What if the Fed is wrong and what is coming down the pike is not high inflation but a bout of deflation?
The Fed and other central banks have already front-loaded rate hikes at an unprecedented pace and we’ve seen inflation taper out — albeit, still high, but not trending upwards. You’ve got to think that the only reason inflation would rise again is with another shock. The first shock was the Covid supply shock which was then followed closely by another massive inflationary shock — the Russia/Ukraine war. So, now that these inflationary events have been fought with rising rates, it might make a lot of sense to see what these hikes will do over the next while as higher rates permeate through the economy.
The Fed is comfortable with seeing higher unemployment, and clearly, investment accounts getting destroyed if it helps bring down inflation to their 2% target. However, the risk is that they go too far and throw the economy into a deflationary spiral. Just like how inflation came on — slowly, and although the Fed was worried, they deemed it transitory until it was too late — deflation can come on the same way.
Good deflation (the type Cathie Woods is betting on) is when there is an increase in the supply of goods and services in an economy which typically results from technological progress, the discovery of new resources, or an increase in productivity. In this case consumer’s purchasing power increases over time and their living standards rise as the increasing value of their wages and business incomes allow them to purchase, use, and consume more and better quality goods and services. Sweet!
Bad deflation, which is what some folks are fearing today, is when prices of goods and services are falling because of a lack of demand (money supply). We’ve been in an inflationary environment brought on by extremely loose monetary policy for over a decade since the GFC in 08-09’. Businesses were born on cheap money and depend on it to finance ongoing operations and growth. Consumers have also come to finance more and more of their spending by borrowing heavily rather than self-financing out of ongoing savings. Now that this has been flipped on its head there is a ton of pressure on heavily indebted businesses, consumers, investors, and ultimately the banks and other lenders.
If Powell gets his wish and we see a big tick up in unemployment, continued destruction in the stock market, mortgage defaults, etc., in return for lower inflation — consumers will likely stop spending leading to falling prices. Falling prices put even more pressure on indebted businesses, consumers, and investors because the their debts remain fixed as the nominal value of their revenues, incomes, and collateral falls. This is where the cycle of debt and price deflation could spiral leading to a horrible recession as businesses fail, people become bankrupt, and unemployment rises.
Let’s hope the Fed can keep inflation in check, while also avoiding a historically rare deflationary spiral.
Have a nice weekend!