Inflation AND deflation at the same time? Economic straws in the wind


by futurist Richard Worzel, C.F.A.

I’ve noticed a strange development recently: two indicators that I follow for inflation and deflation are both rising, implying that we may be headed for a period of both inflation and deflation at the same time. Since no reputable economist that I’ve ever read would conceive of such an apparent oxymoron, this caught my attention. First let me describe the indicators, discuss how it might happen despite the apparent contradiction, and then talk about some of the potential implications and what you might do about them.

These indicators are based on the number of times the words “inflation” and “deflation” appear in online news media, as counted by, and I’ve been tracking them weekly since September, 2005. Because they’re based on media reports, they probably indicate more about sentiment than about economic developments. This idea is based on a similar indicator that I follow that tracks the incidence of the word “recession.” It’s been known for decades that tracking the incidence of “recession” can be a leading or real-time indicator of recession, in part because it may become a self-fulfilling prophecy: the more people talk about a recession, the more worried they’re likely to be – and become – about the possibility. Below is the “recession” indicator up to this week. Because a recession is a negative thing, I’ve inverted the Y axis, so that the greater the number of times that the word “recession” appears, the lower the line falls.

You’ll notice that the indicator implied that the economy collapsed in October of 2008, bounced off the bottom in February of 2009 and began a rapid climb back, but then slowed significantly in the late Spring or early Summer of 2009. Since mid-Summer of 2010, the indicator has essentially stalled. This pretty much matches what the economy has done: the world didn’t end, and the economy did recover, but hasn’t come even close to recovering its pre-crash strength. Now we seem to be experiencing slowing economic growth, and a sluggish, painful recovery. Moreover, if anything, this indicator foreshadows even more anemic growth ahead for America – not a double-dip recession, but barely a recovery. This will have significant implications in a whole range of areas, including the 2012 presidential election. I’ll circle back to these implications a little later.

Now let’s look at what the “inflation” and “deflation” indicators seem to be saying:

First notice that from August of 2008 (line A) until December of 2009 (line C) the use of the term “inflation” declined dramatically. This is to be expected, as a softening economy isn’t expected to have rising inflation, so inflationary expectations would naturally be in decline as the economy went into recession. Next, notice that the incidence of the word “deflation” started to shoot up in August of 2008, just as the incidence of “inflation” was falling. This, too, is to be expected: when an economy goes into severe reversal, the possibility of deflation grows substantially.

Why deflation is so dangerous

Incidentally, deflation is much more dangerous than inflation. If consumers think that the price of a car, for instance, is going to be lower next month than this month, they will tend to postpone buying. But if next month they expect it to be lower still the month after that, they will continue to wait. This creates a downward spiral of consumers withholding purchases, which lowers demands, which causes prices to fall, which causes consumers to postpone purchases further, and so on. This kind of stuff makes central bankers wake up screaming in the night, and explains why virtually all of the major central banks flooded the world with liquidity by printing money during the dark days following the Panic of 2008.

Interestingly, the incidence of both inflation and deflation declined around December of 2008 (line B). I interpret this as meaning that although the economy was still in recession (so that inflation expectations were low), folks concluded that the world was not going to end, so that concerns about deflation began to fall as well. This continued up to line C, in December 2009, and it is at this point that something strange begins to happen: expectations of both inflation and deflation begin to rise at the same time, and this trend continues today. What does this mean?

Well, it could mean that these indicators aren’t consistently reliable or worthwhile. I don’t believe this. I think this strange development means something important. Let’s look at the possibilities.

It could just be confusion in the marketplace…

First, it’s clear that there is a lot of confusion in the marketplace, and a lot of disagreement among economists and investors, and the indicators could just be registering the split in opinion. Those who expect rising inflation point to the unprecedented low levels of interest rates and the flood of liquidity produced by central banks. In normal times, you would expect that this would lead to asset booms and rising consumer prices – inflation, in short. Meanwhile, those who expect deflation point to high debt levels, especially in the “rich” countries, which are leading to “deleveraging” (which means paying off debt instead of spending money), and the subsequent anemic demand. They then draw parallels to Japan’s experience since the 1990s, the so-called “lost decades,” when Japan suffered through an extended bout of deflation, and a stalled economy with effectively no growth. It’s pretty clear that most (but not all) central bankers in the developed world fall into this crowd, with Ben Bernanke of the U.S. Federal Reserve leading the pack. Time alone will tell which crowd is right. There are legions of commentators on both sides of the debate, which makes the situation even more confusing.

But let’s consider the possibility that both indicators are right, and that this isn’t an oxymoron: is it possible that we might see pervasively rising prices and pervasively falling prices at the same time? That we might experience both inflation and deflation simultaneously? Well, first we have to explore how that could happen, as it seems to be a contradiction in terms.

…or it could be something much more significant

I think the key is that we are going to see lots of prices rising, and lots of prices falling at the same time, and I think it’s going to happen because of a fundamental realignment in the world’s economic order. The Rapidly Developing Countries (“RDCs”), like China, India, Brazil, Mexico, Malaysia, Indonesia and others, are growing much more rapidly than the developed countries. Indeed, while the developed countries of North America, Europe, and Japan continue to struggle with anemic growth in the range of 2% or less, the RDCs have bounced back vigorously with growth rates in real GDP as high as 10%. Moreover, the RDCs, because of their higher growth rates, represent a steadily increasing share of global GDP. Because of this, the RDCs are having more and more influence on the global demand for goods and services, and particularly for commodities. In particular, they are driving up demand for food, oil, copper, and many other essential items.

Take China, for instance. The average food intake for a Chinese citizen in 1960 was about 1600 calories a day. As China prospered, and developed a middles class, one of the first things its more prosperous citizens did was to feed their children and themselves with more and better food. As a result, by 2000 the average Chinese was consuming 2600 calories – and an increasing share of that 2600 calories was in the form of meat, which takes far more resources to produce – and is therefore substantially more expensive – than an equivalent number of calories from grain. Moreover, Chinese population doubled in that period, from 660 million to 1.3 billion. The overall result was that China, as a nation, tripled its consumption of food in a 40-year period – an astonishing rate of growth. And the same increase in middle class prosperity also drives the demand for consumer goods and the means to produce them (although not as dramatically as the demand for food).

Now step back and consider that the same thing is happening in all of the other RDCs: as their billions of people move out of poverty into a more prosperous middle class, their demand for goods and services, especially food, will skyrocket. And this is going to be the major driver of global growth in demand for food, for consumer goods, and for the plant, equipment, and materials needed to produce them. As a result, I fully expect that the global economy is going to experience significant inflation, starting with food and energy.

While the RDCs grow quickly, the developed countries get poorer

Now let’s talk about what is happening in the developed world. The economies of North America, Europe, and Japan are experiencing continuing and protracted weak growth, high rates of unemployment, and a fear-inspired desire to pay off some of the mammoth debts that they have incurred. The result is that demand will be weak, and companies will struggle to sell their goods and services. At the same time, competition from the emerging economies of the RDCs, coupled with increasingly powerful and sophisticated automation in the developed world, is putting downward pressure on the prices of consumer goods, most of which are at least to some extent discretionary. Families can usually postpone buying a new car, have a washing machine fixed instead of replaced, or tell Junior that he has to live with his 3-year old game console instead of getting a new one. The result is that the setting is right for deflation in many consumer goods. Consumers will step back from that marketplace – indeed, in many areas, they have already stepped back – which will put downward pressure on demand and prices. And when consumers see that prices of consumer goods are falling, they may decide to wait some more – especially as an increasing share of their paychecks may be being taken up in buying essentials like food and energy. This puts further downward pressure on demand and prices, which encourages consumers to wait even more.

What this means is that the cost of essentials will go up (inflation), while the prices of discretionary goods will go down (deflation). And what this means is that consumers in the developed world effectively become poorer, spending more of their incomes on essentials, and less on discretionary luxuries, even as consumers in the RDCs move out of poverty, and start having more money to buy things beyond the essentials. This development could mean that there is a further leveling of standards of living between the “rich” world and the “poor” world.

Now let’s look at some of the implications of all this, and let me start with something that’s a truism in the futurist community: Someone always benefits from change. Given the relatively bleak outlook in the developed world, the first and most obvious way to benefit from the changes that I’ve projected would be to focus on building business in the RDCs. That’s easier said than done, but is clearly something that all businesses should be thinking about.

Someone always benefits from change

This truism also means, though, that companies should be looking for opportunities at home as well. Let me draw an analogy. I’ve written two books on entrepreneurship, drawing on my experience working with entrepreneurs when I worked in venture capital financing. One of the things I suggested to those wishing to start a business is that they should look at entering mature, slow-growth or even declining businesses, which I collectively called “ugly industries.” The reason I suggested this is that such industries attract very little competition, and the entrenched companies tend to plod along, doing the same old things in the same old ways. Accordingly, it’s often relatively easy to enter such industries with fresh perspectives, new ideas, and pick up market share relatively easily. And if you can gain market share, even in a declining industry, you can make good money.

Likewise, in the current environment, many companies have just hunkered down, and are waiting for good times to return. They’ve laid off people, slashed advertising budgets, and are mostly relying on price cutting to maintain their markets. This makes it a great time for companies with imagination and a willingness to innovate to come up with new offerings, better offerings, more efficient products, more inventive pricing, hire creative people, and generally wreak havoc on their catatonic competitors. I’m not saying this will be easy, but the history of business is filled with companies that started and thrived in bad times, including GE (1873), Newsweek magazine (1933), Hewlett-Packard (1939), Hyatt Hotels (1957), Fedex (1971), CNN (1980), and Flickr (2004).

This is the new normal; get used to it

The next implication is that you shouldn’t wait for the economy to return to “normal,” meaning the way things were in the mid-2000s, or even the late 1990s. This is the new normal; anemic growth is going to be with us for some years to come while consumers pay down debts, and governments struggle to get their financial houses in order. Indeed, if you’re a pessimist, it can be argued that things aren’t going to get better, and the days of easy living are over for good, in part because of the aging of the boomers in the developed world, and the burden their retirement and health care needs will place on our governments and economies.

Turning to the implications for politics, bad times breed voter discontent. The pivotal moment in the Reagan – Carter debates was when Ronald Reagan asked voters “Are you better off than you were four years ago?” Voters decided they weren’t, and the peanut farmer went back to Georgia, while Reagan went to the White House. Indeed, the single most reliable predictor of American electoral success is how Americans’ personal incomes change in the year before an election. That would seem to strongly indicate a large Republican victory in this year’s mid-term elections. And given the outlook for America over the next two years – continued sluggish growth and high unemployment – I would guess that there’s an excellent chance that Obama will be a one-term president regardless of what he has done or will do in the next two years. He fell into an enormous mess but will get the blame for not fixing it.

The greatest danger

Next, there’s a very real risk that voters in the developed world will conclude that our problems here are being caused by workers in the RDCs stealing jobs, income, and prosperity from us. There is a tiny grain of truth in this, but nowhere near as much as people believe. It is true that China is cheating by keeping its currency artificially low, and that they are doing it to give their exports an unfair advantage in world markets. But it’s not as clear that if they let their currency appreciate significantly that it would make all that much difference to American workers or the developed economies. It would remove a significant irritant from global trade, but it would not be a panacea that would fix everything. And if China does not let its currency float, and America decides to impose punitive measures, this could lead to a truly devastating result: a global trade war.

This has happened before. There was an emergence of a global economy at the beginning of the 20th Century, starting with the reduction in tariffs in the 1890s among the major trading nations, and it caused a global boom. Indeed, one of the reasons that Roaring 20s roared was because global trade soared. The stock market collapse of 1929 exacerbated already mounting trade irritants, which produced mounting pressure on politicians to start protecting domestic jobs and industries. Protection always sounds like a good idea, but it only works if your trade partners let you get away with it by not reacting. Since that doesn’t happen, protectionism on one side breeds retaliation on the other side, which provokes counter-retaliation, and so on. In particular, the Hawley-Smoot Act passed by the U.S. Congress in 1930, and named for the two Republican senators who sponsored it, raised tariffs to levels that had not been seen since 1828 in order to “protect” American industries and American workers. Economists by the dozens begged President Herbert Hoover to veto it, but he signed it anyway, triggering equally massive retaliation by America’s trading partners. As a result, global trade fell by two-thirds in the three years from 1929 to 1932, pushing the world into a downward economic spiral which was only relieved (if that’s the word) by World War II. This is one of the lesser-known, but more important, causes of the Great Depression of the 1930s.

Ironically, all governments know that protectionism doesn’t work, and that a trade war would badly hurt everyone. Yet, in the heat of the moment, with voters demanding action, who knows what a nervous government might do?

One inescapable conclusion

Whether my interpretation about the possibilities of these two indicators turns out to be correct or not, one thing is clear: we are in uncertain and dangerous times. There are few useful precedents, and the risks are great. In particular, watch what happens with the currency wars, and be prepared to take unusual, even drastic steps to protect yourself, your business, and your family for the difficulties ahead. This is not a drill.

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  • Ray Oct 24, 2010

    Good article. I would concur.

  • Sandy Oct 25, 2010

    Very thought provoking. Something I haven’t heard anywhere else. Thank you.