- The inflation/deflation debate boils down to whether the surge in government bond issuance and money printing will continue to be offset by an even greater increase in money hoarding.
- The rise in the ratio of money supply to GDP (so-called declining velocity) reflects a rise in potential inflation rather than an argument for deflation.
- The inflation outlook will also depend on which members of society receive the additional supply of money.
- With the prospect of additional and larger stimulus check issuance gaining momentum, money looks set to increasingly flow into the hands of those with a greater propensity to spend it, suggesting inflation pressures will rise.
Macroeconomists are split on the key issue of inflation versus deflation and there are valid arguments being made on both sides. The debate ultimately boils down to whether the surge in government bond issuance and money printing will continue to be offset by an even greater increase in the willingness of individuals and businesses to hoard cash. This in turn will depend on which members of society receive the additional supply of money. With the prospect of additional and larger stimulus check issuance gaining momentum, we think the odds are heavily stacked in favour of rising inflation.
Deflation arguments tend to focus on a collapse in demand that will offset the impact of rising money supply growth. However, while the growth of a certain good is driven by demand for that particular good, the demand for all goods and services in an economy is infinite (people will always want more stuff). This is the essence of economics: how to satisfy infinite demand with finite resources.
Inflation is not driven by ‘demand’ but by spending, which is driven by the amount of money that people have and their willingness to exchange it for goods and services. For any given level of goods and services available in an economy, the greater the amount of money people have, all else equal, the higher prices will be. This means that the fewer goods and services that are produced relative to the amount of money, the higher prices will tend to be. This is not a difficult concept to understand at the individual product level; just look at the price of PPE equipment and hand sanitizer in recent months. It is no different at the economy-wide level. Too much money chasing too few goods will lead to higher prices.
Lockdowns Have Led To Temporary Involuntary Hoarding
The current economic climate should theoretically be highly inflationary, then. A contraction in the availability of goods and services combined with a rapid increase in the supply of money is the ideal recipe for inflation. However, one crucial factor to consider is the demand for money. There has been a temporary period during lockdowns when people have simply been unable to spend the money they have of many things they would otherwise want to spend it on. Even amid a surge in the availability of money and a collapse in the availability of goods and services, if individuals and businesses hoard the money as a store of value to buy goods and services in the future rather than today then this can overwhelm the direct inflationary forces.
However, this is highly unlikely to last given the sharply slowing rate of new COVID-19 cases. Even if lockdowns are extended longer than expected, the ratio of money supply to GDP will continue to rise as policymakers respond to economic weakness with fiscal and monetary stimulus measures, which will store up greater inflation potential for the future once this money is spent. M2 money supply has surged by almost 2T since the beginning of March – a 100% annualized increase – at the same time as real GDP has fallen. Over the coming months and years we are likely to see this new money get spent, driving up prices.
Declining Velocity Is Actually Rising Potential Inflation
The demand to hoard money as a store of wealth is often mistakenly characterized as the velocity of money, defined as the number of times that the average unit of currency is used to purchase goods and services within a given time period. In reality, inflation has absolutely nothing to do with how often money changes hands. A great article by Frank Shostak explains the failings of the notion of money velocity here, quoting the godfather of Austrian economics Ludwig von Mises:
The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics. – Ludwig von Mises
Deflationists often point to the chart below of the declining ratio between M2 and nominal GDP (the so-called velocity chart) as evidence that inflationary pressures will remain weak despite the rise in money supply. However, we think it is more appropriate to view this ratio the other way round and to interpret it as a surge in potential inflation.
The rise in the ratio of money supply to GDP reflects a rise in potential inflation as there is no guarantee that individuals and businesses will continue to increase their desire to hold money as a store of value. Given the huge rise in the stock of money relative to the size of the economy, and the high likelihood that money supply will continue to rise sharply, it would only take a slight decline in the willingness to hoard this money to see prices rise sharply.
The outlook for inflation will ultimately depend on whether we see a surge in the demand for money as a store of wealth offsetting the inflationary force of money supply continuing to exceed real GDP growth at an increasing clip. This seems highly unlikely to us.
Who Gets The Money Will Be A Crucial Determining Factor
To understand whether the rise in money supply relative to the availability of real goods and services will lead to rising prices we need to understand who will actually end up holding this money. If, as was overwhelmingly the case following the Global Financial Crisis, the increase in money ends up in the hands of the wealthiest members of society, there is no guarantee that it will be spent as wealthy individuals and businesses have a much lower propensity to consume. If, on the other hand, the money increasingly finds its way into the hands of poorer members of society with a higher propensity to consume, we will likely see a surge in prices of everyday goods and services. Our view is that stimulus measures will become increasingly generous, resulting in a greater share of money in the hands of people willing to spend it. The proposal to give USD2,000 per month to every American age 16 and older who earns less than USD130,000 a year for at least six months is reportedly gaining steam. If such a policy is enacted we are likely to see inflation rise dramatically.