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Inflation turns to deflation as stimulus debt now has to be repaid

Economic growth
By Paul Hodges on 21-Aug-2015

China PPI Aug15Its not what we know that causes the major problems.  Its what we think we know, but don’t.

We know, for example, that markets balance supply and demand by shifting prices up and down.  Too much demand and/or too little supply, will mean higher prices and inflation.  This is what happened as the BabyBoom took place:

  • Medical advances and high fertility rates meant that the world population nearly doubled between 1950 – 1980, from 2.5bn to 4.4bn
  • Yet supply was still recovering after the destruction caused during World War 2
  • The result was major inflation, as prices moved higher to effectively ration demand.

But central banks instead think they know from their theoretical models that inflation is really caused by printing too much money.  They follow Milton Friedman’s theory, who won a Nobel Prize in 1976 for his argument that:

Inflation is always and everywhere a monetary phenomenon”

As a result, they have now spent nearly $25tn since 2009 in stimulus spending.  Overall, global debt has risen by $57tn since 2007, taking it to 3x GDP at $199tn.  The idea was that printing all this money would generate inflation, and lead to economic recovery.

But as the chart shows, the policy has failed, utterly and completely.  Inflation did rise temporarily as the stimulus began.  It then peaked in 2011, and has since been falling quite sharply.  This is despite the major new stimulus spending from Abenomics in Japan since 2012, and Draghinomics in the Eurozone since March this year.

Instead, the gradual removal of stimulus in China, under its New Normal policies, is creating long-term deflation:

  • China’s Producer Price Inflation has been negative for 3 years, and was -5.4% last month (red line)
  • China’s role as the manufacturing capital of the world means this deflation is being exported to consumers
  • UK Consumer Price Inflation (CPI) peaked at 5.2% but is now just 0.1% (purple)
  • Japan’s CPI peaked at 3.7% after the start of Abenomics, but is now back at 0.4% (yellow)
  • US and Eurozone CPI are also now close to zero at just 0.2% (green, blue)

And, of course, these CPI levels will likely fall further under the impact of the ongoing collapse in commodity prices and the lower import prices caused by China’s devaluation.

Debt and deflation are a toxic combination, as the value of debt increases with inflation.  Debt reduces spending power, whilst deflation leads consumers to defer purchases as prices will be lower tomorrow.   It therefore seems most unlikely that the next few years will be “business as usual” for most companies and investors.