Before addressing the likelihood of deflation, one must look at some of the main driving forces behind inflation to analyze if these are sustainable over the long run.
Professor Milton Friedman described inflation as a ‘monetary phenomenon’. The more money is being created in an economic system, the greater the likelihood of an inflationary outcome. Too much money leads to an imbalance between demand for, versus the supply of, a limited amount of goods and services, which ultimately drives up prices.
There was one caveat in his thinking: the velocity of money. Money creation without any velocity limits its circulation, which in turn constrains the consumption potential. If money is saved rather than consumed for example, the resulting upward pressure on inflation will be marginal.
Money creation and its velocity, combined, are the fuel rods of inflation.
Professor Richard Werner empirically proved money creation to be a variable of private commercial bank lending.
The extension of credit by the private banking sector is subject to numerous limitations. These include regulatory restrictions, the size of a bank balance sheet, defaults a banking institution needs to contend with, the quality and value of collateral backing a loan, the viability of an economic project to be financed, the profitability of credit determined by its interest rate charge, as well as the short and long term ‘credit cycles’ dear to Ray Dalio. To name but a few …
Private commercial banks are generally leveraged entities. As such, they tend to be risk averse. Any impairment to their balance sheet, however small, can place them in a precarious situation.
During times of economic uncertainty, banks will choose to be even more restrictive in their lending practices, reducing their loan book rather than increasing it.
On the other side of the lending equation are private borrowers. For them to take on new debt, they need to be confident in their capacity to repay it from existing or projected revenue streams. When an asset is pledged as collateral, its quality and value needs to be sufficiently sound to secure a new loan. For a corporation, the expected returns of any investment must to be in line with its profit objective, before entertaining any credit financing facility.
In sum, the confidence to repay, to secure, or to generate profits, is a determining factor in the willingness or not to take on new debt.
Economic uncertainty will only lead to an impairment of this confidence, and a reduction in aggregate demand for private sector borrowing.
In the present-day environment, uncertainty is everywhere. Unstable commodity and energy input prices coupled with an unsettled geopolitical environment are teaming up with higher costs of living, disrupted supply side issues and tighter monetary policy. Together, these ingredients cloud the road ahead to any future economic prosperity. With money creation slowing through reduced private bank lending and a weaker appetite to borrow, at some point, inflation pressures from money creation, which drive the demand side for goods and services, should start to fade.
Velocity of Money
Assumed to be a constant in 1970s, velocity turned out to be a declining factor over the last decades.
One of the reasons put forward is the changing spending dynamics of a demographically ageing population. Consumption and saving habits evolve through life. For an older generation, greater emphasis is put on setting aside for retirement rather than borrowing for consumption.
Further to this long-term trend, the wealth destruction in 2022 is threatening the traditional savings ‘next egg’. As a result, aggregate consumption, especially for non-essential items, is unlikely to be supported moving forward, favoring of a higher propensity to save instead.
EuroDollar system for those outside the US.
The EuroDollar system represents US Dollars outside of the domestic US monetary system. Like any other credit-based currency system, its inflationary dynamics are also carried by ‘money creation’ from non-US domestic bank lending, as well as the velocity of money through international commercial transactions.
The US Dollar has a unique status of being the world’s reserve currency. It provides both a consumption capability for foreigners, as well as a warehousing capacity for world savings. Money creation and velocity in the EuroDollar system are also a driving force behind world inflation.
However, this market has been severely impaired for months now. The non-US world is now structurally starved of Dollar liquidity. This points to unsustainable world demand for goods and services needing to be paid in US Dollars.
For ‘Crossborder’ Capital, world Capital markets have become overwhelmingly a refinancing mechanism of existing debt. They have enjoyed, and become dependent on, cheap readily available liquidity to function in an orderly manner over the last decade.
Today’s world financial system needs new US Dollar money creation to ensure sustainable global aggregate demand, on the one hand, but also to fulfill this fundamental refinancing role for a large pool of outstanding US Dollar of debt, on the other.
Without it, one can expect some kind of liquidity crunch. This is already taking place at the periphery of the financial Dollar system. Numerous emerging markets are being strongly affected by this lack of US Dollar funding.
Bankruptcies could lead to loan defaults, constraining private lending in US Dollars, even further.
Federal Reserve policy to address a lagging indicator
Global US Dollar private monetary creation is on the decline. The world velocity for the American currency is disrupted, especially in the EuroDollar system. Capital Markets are teetering on the verge of a liquidity crunch. What then is left to ensure the necessary conditions to support money growth through new lending, increased demand, and higher inflation?
The present day inflation is a spillover from massive governmental handouts and loose ‘unsterilized’ monetary support during the Covid pandemic. This ‘largess’ has been sustained through uncontrolled deficit spending.
Today’s tighter financial conditions are kicking in to address this monetary issue. However, inflation is a lagging indicator. As this Central Bank’s policy is being rolled out, it will just add to the growing uncertainty, and loss of ‘confidence’ mentioned earlier.
This does not point to a sustainable inflationary environment over the long run. On the contrary, it could even usher in a deflationary scenario instead.
Debt, both public and private, is at historic levels thanks to twelve years of over abundant liquidity, subsidized by artificially low interest rates.
Central Bank policy has a more far-reaching impact than at any other time in history due to the quantity of credit still outstanding. As such, the Federal Reserve’s actions could accelerate this transition towards a deflationary environment.
Their present day actions are echoing those of past political choices. In Great Britain for example, the money supply was expanded dramatically to pay for the ‘Great War’. During the 1920s, the then Chancellor of the Exchequer, Winston Churchill, restored the gold standard peg to its 1914 level, so as to shore up his currency from the inflationary pressures emanating from this over-abundant supply of money. In doing so, he placed a financial straight jacket on his economy, driving the country into a deflationary spiral.
Is Chairman Powell about to do the same, a hundred years on?