Central banks in many advanced countries have kept interest rates near historic lows for half a decade. The express fear is deflation. However, low rates have so far failed to spark growth. On the other hand, they have given rise in some quarters to worries about inflation. Too much money is flowing through the economy. It’s not an academic debate. It will determine which investments are best for the medium term.
Deflation is here to stay
For behavioural economists, investors tend to evaluate the present – and the future – by what they’ve seen in the past. That compass is not unerring, of course.
So is deflation, as experienced by most advanced countries since the financial crisis of 2008–2009, here to stay? Many economists dismiss the possibility. The global economy has gone through a shock, but has recovered. Now the normal inflationary pressures will mount, with central banks poised to shut off the liquidity taps at any moment.
But what is normal?
Unemployment in North America remains stubbornly high – and probably understated, since many workers have left the workforce permanently. Household debt is also at historically high levels. As a result, consumers don’t have a lot of purchasing power – and it is they who have fuelled economic growth over the past two decades. Beyond that, there has been a surge in food prices.
Even in areas where Canada has seen marked growth – namely energy – companies are pulling back on new projects that may not be able to earn their keep. Elsewhere, corporations are sitting on record piles of cash. Why expand when there is no consumer demand?
In short, we may have arrived at a new normal: sub-par GDP growth at 2%, accompanied by flat prices. Is that improbable? Just look at Japan, which has been mired in 20 years of slumping prices and less- than-stellar job creation. Despite maintaining a zero interest rate policy for more than a decade, the Bank of Japan is still pushing on a string. Massive infrastructure projects have failed to boost growth in a country with an aging population who are saddled with homes bought at peak prices in the late 1980s and who have recently found a taste for discounted goods.
Inflation is on the way
Two of the past three Canadian recessions have been brought on by central bankers suddenly shutting down the money supply. They raised interest rates to record levels in 1981–1982 and the same again in 1991–1992.
A good dose of medicine, some would argue. It shut down the housing market. Companies, faced with automatic cost-of-living allowances, laid off workers. In the end, higher interest rates turned out to be a better strategy for reducing inflation – and restoring the confidence of bond holders, many of them retirees – than the failed 1970s experiments of wage and price controls.
Arguably, central bankers have forgotten this. At some point, bond vigilantes will demand higher interest rates, before governments try to inflate their way out of deficits, printing even more money – just as Weimar, Germany did with Rentenmarks, a currency based not on gold, but on the notional value of the land base of Germany.
Paper money is a fiat currency – its face value is determined by governments, but without hard assets to back it up, markets will determine its real value. And they may, as they did with the Zimbabwe dollar, determine that the paper currency is worthless.
But it’s not just about printing paper. If anything, the consumer price index understates inflation. There are sectors of the economy where inflation is endemic. Healthcare stands out as one. That cost will be passed on.
In short, the inflation pot is bubbling.