Inflation vs. Deflation—What’s at Stake

First, let me start with a tweet by Larry Summers, though this chart has been passed around by Andreas Steno Larsen and others.

lawrence summers

If you’re not hip, basically, this is a chart of current inflation on top of the inflation in the 1970s. The implication is that we will have a bigger round of inflation down the road, three to four years from now.

First, I’m not a big fan of analog charts. History may rhyme, but it never repeats.

One reason inflation might come back with a vengeance: Even though the rate of inflation has fallen, we still are in possession of an inflationary psychology. People expect prices to rise, which causes them to act in ways that will cause prices to rise. If you want to eliminate the inflationary psychology, you need to cause a real honest-to-goodness recession, which brings about the associated deflation necessary to soften inflation expectations.

The Fed has hiked rates a lot, though it hasn’t caused a recession yet. That may happen still—monetary policy works with a long lag. We are seeing some signs that things are slowing down. As of recently, there are some cracks in the housing market. And the banking industry is not too healthy.

One reason inflation might not come back with a vengeance: China. China is in the midst of a great deleveraging. Prices are falling, and as the world’s second-largest economy, it will export that deflation to the rest of the world. That seems likely to happen. All its economic indicators—at least the ones it has left—are in freefall. It may even have a depression, which might have some unholy consequences. So that is one reason to believe why we won’t have Round 2 of inflation.

Honestly, I am a bit torn. I think either could happen. Maybe they both happen in sequence. Maybe something in the middle is the right answer. I’m not sure the Fed knows the answer either, but the Fed (correctly) sees greater risks to inflation than deflation. If only it believed that a few years ago.