We're All Talking About Inflation, But Deflation May Also Be On The Way

Most recent data continue to show a visible acceleration in "price inflation," with the yearly growth rate of the US Consumer Price Index (CPI) rising to 6.2 percent in October from 5.4 percent in September and 1.2 percent in October of last year—its highest level since December 1990.

Most experts seem to be surprised by the massive increase in the momentum of the CPI in October. Based on the definition of inflation as increases in the money supply and not increases in prices, the sharp increase in the yearly growth rate of the CPI is predominantly on account of past massive increases in money supply.

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Note that the yearly growth rate of our monetary measure for the US stood at 79 percent in February 2021 against 6.5 percent in February 2020. Given the time lag between changes in money supply and changes in the CPI, it is quite possible that the yearly growth rate of the CPI will strengthen further.

However, on account of the sharp reversal in the momentum of money supply, the momentum of the CPI might also follow suit. A sharp decline in the yearly growth rate of the Austrian money supply (AMS) measure to 17.9 percent in September 2021 from 60 percent in September 2020 raises the likelihood that the momentum of the CPI will visibly weaken ahead. We suspect this outlook could emerge in the latter part of next year (see chart).

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If this were to eventuate, then the likely decline in the yearly growth rate in the CPI ahead raises the likelihood that most commentators will start warning about deflation, i.e., a general decline in the prices and the threat that this will pose to the economy.

A general decline in the prices of goods and services is regarded as bad news since it is seen to be associated with major economic slumps such as the Great Depression of the 1930s.

In July 1932, during the Great Depression, the yearly growth rate of industrial production stood at –31 percent while the yearly growth rate of the CPI bottomed at –10.7 percent in September 1932 (see charts).

(Click on image to enlarge)

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According to commentators the possibility of deflation is a major worry. That is because when prices fall it is harder for borrowers to pay down existing debts, leading to growing defaults, while banks become reluctant to extend credit. The logic runs that these two factors combined generate a downward spiral in credit creation and resultant economic activity. Furthermore, most experts regard a general fall in prices as always "bad news" because it slows down people's propensity to spend, which in turn undermines investment in plants and machinery. These factors are further argued to set in motion an economic slump. Moreover, as the slump further depresses the prices of goods, this intensifies the pace of economic decline.

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