The case against inflation is pretty straightforward. With gross domestic product (GDP) growth slowing all over the world, demand for commodities has fallen off a cliff. And since the mainstream view is that the world economy is not going to go back to its previous rate of growth any time soon, the demand for commodities, too, will not rise so much. Hence, inflation will be kept in check. Another point is that the central banks may increase money supply, but the velocity of money has gone down because consumers don’t spend and as a result the excess funds do not translate into inflation in goods and services. That may be correct, but what about asset inflation?
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That’s where the other argument comes in—that although central banks have all been increasing liquidity, that is more than offset by the deleveraging that has gone on in the “shadow banking system”, and the closing down of the “credit factories” will mean liquidity will again not be as abundant as it used to be. The problem with that view is that stocks have been going up quite sharply in recent weeks across the world, fuelled by the reappearance of liquidity. Commodity prices, too, have moved up. Crude oil prices have improved quite a bit.
But what is the historical record? The Great Depression, for example, is known as a period of falling prices. The chief of a large fund house in India, however, recently told me that view of what happened during the Great Depression is seriously flawed. A look at the historical data on US inflation shows that even before the crash of 1929, the environment was mildly deflationary—for instance, the consumer price index (average for the year) fell by 1.92% in 1927 and by 1.15% in 1928. In 1929, the year of the Great Stock Market Crash, average inflation was zero in the US. The numbers show that it’s absolutely true that during the years 1930-1932, deflation was rampant, with the average consumer price index falling 2.31% in 1930, 8.94% in 1931 and 10.3% in 1932. That should not be surprising—as financial consultant Daniel R. Amerman has pointed out, “The United States gross domestic product was $103 billion (around Rs5 trillion today) in 1929. By 1933, it had fallen to $56 billion, a decline of 46%.” But 1933 was the year president Franklin D. Roosevelt assumed office and started on his New Deal programmes of fiscal expansion. The average consumer price index went up 3.51% in 1934, and a further 2.56% in 1935. The reason for this turnaround, says Amerman, is because Roosevelt abandoned the gold standard: “From 1900 to 1933, the US government had been on a gold standard, and had issued gold certificates. In a matter of days in March of 1933, there would be a radical change, a veritable 180 degree turn, that would not only repeal the gold standard, but effectively make the use of gold as money illegal in the United States.”
In short, if faced with deflation, all that a government that is not tied to the gold standard has to do is print money. Hence, Ben Bernanke’s smug talk about dropping money from helicopters.
But how can inflation rise when demand is so low? Well, for one thing, governments are not sitting idle but are going in for large doses of fiscal stimulus. Also, it’s not just demand we should be looking at, but also supply.
Mohammed A. El-Erian, chief executive officer of Pacific Investment Management Co. Llc., says, “For now, it is hard to project any imminent pickup in inflation given the severity of the collapse in global demand and the resulting large output gap. Private components of global demand will not recover quickly and fully. Yet, one should not fixate just on demand when transitioning from a cyclical to a secular mindset. Supply also matters. In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation and government intervention will be among the factors that will constrain the growth of potential (non-inflationary) output. With investment activity subdued for a while, the rate of depletion of the capital stock will rise.” In other words, demand may be low, but so will supply be.
Inflation is also good for the stock markets. During the Great Depression, the Dow Jones Industrial Average (DJIA) reached a high of 386 in 1929 before starting to fall and by February 1933, the DJIA was at 50. Thereafter, it rapidly moved up to around 100, where it stayed for a long while before starting to go up again in 1935. Towards the end of 1936, the index stood at around 180 before it fell again as the New Deal ran out of steam. To cut a long story short, while some amount of goods and services inflation returned to the US in the 1930s, asset prices, too, went up substantially.
That is what seems to be happening at present also. With the real economy subdued, the massive monetary easing is raising asset prices, though we may have to wait some more time for inflation to return.
Can asset prices go up even further? This is what Morgan Stanley’s Joachim Fels and Manoj Pradhan had to say: “The Fed (US Federal Reserve) is not even halfway through its announced QE (quantitative easing) programme. So, even more liquidity will be made available over the next several weeks and months to help prop up asset markets, balance sheets and the real economy.”
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com