Is inflation or deflation coming?

Photo by Lloyd Blunk on Unsplash

Most of the economists agree that inflation is coming at some point in the future. In fact, higher-than-expected inflation is the greatest fear among investors today. But there is no consensus on how and when this inflation will take place. First of all let’s take a global picture to see the current situation:

– Yield curve model: the spread between the 10year and 3month US Government debt is now at an average spread, but was recently inverted. Historically this has been an indicator of a recession in the following 12-24 months.



– Buffet indicator model: this is the ratio of total US stock market valuation to GDP. Currently is at 226%, which means the market is currently strongly overvalued.

– P/E ratio model: the price-earnings ratio is the ratio a company’s share price to the company’s earnings per share, indicating how many years of current profits it takes to recoup an investment. Average ratio is considered to be 19.6 and currently the aggregate S&P500 P/E ratio is 36.27. An indication that the market is strongly overvalued.

So the question is: does the current overvalued market lead to immediate inflation right away?

50% of all the US dollars that ever existed were printed last year

Economist that support the immediate inflation pathway argue that Central banks not only have increased the money supply for decades but also have accelerated this pace during the recent years through:

– Quantitative easing: the Fed provides liquidity to the economy purchasing bonds of the balance sheets of investment banks.

– Direct payments to consumers: by giving money to people unemployed you increase demand for goods and services from those who are working.

Basically the idea they hold is that when there is oversupply of the currency, the value has to fall at some point, sooner rather than later. Several economists support this idea, including Peter Schiff, Ray Dalio and Michael Burry. They believe the US dollar will fall rapidly.

Brent Johson’s dollar milkshake theory

Other economists believe a deflation period will occur prior to the inevitable inflation. Looking into data, in 2008 the Federal Reserve balance sheet was 0.8 trillion dollars and in 2014 (when the QE III ended) it was 4.5 trillion dollars, so in almost six years the money supply was increased more than four times and guess what: there was no inflation! So does printing money produce inflation immediately?

Source: Federal Reserve via Haver Analytics

Economists supporting this idea argue that what causes inflation is not printing money but the velocity it moves. For them nominal GDP is equal to money supply times velocity. Basically they think that if people are fearful or concerned about uncertainty they will save money as much as possible. In the US the savings rate had been going up to 33% during last April 20’.

Source: Statista 2021

Some economists that support this deflation period are Jeremy Grantham, Brent Johnson or David Hunter for example. Basically they point out that all the leverage that is placed in the system will cause some level of deflation first, before the inflation finally comes.

For them the US dollar is currently the reserve currency and therefore it will behave differently than any other currency even during times of massive monetary supply expansion.

The dollar milkshake theory from Brent Johnson explains that the US dollar is going to get squeezed much higher. Despite that many investors are moving away from assets denominated in US dollars, the US and many other countries have taken out an incredible amount on US dollar debt. That debt either gets paid of or defaulted on. Brent Johnson basically thinks that there is no way that debt is going to get paid off, assuming that there are not enough dollars to go around. This theory considers that default destroys money, “makes money disappear”.

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