Inflation or deflation?

Source: BCE

These approaches were, to a lesser extent, tried out after the great recession of 2007-2009. But, if on the one hand there is a vertiginous rise in the stock of money and therefore legitimate expectations of inflationary fears, the truth is that the ratio of the speed of money circulation has been falling consistently over the last two decades. That is, expectations of economic contraction and deflation.

Shocks caused by the dynamics of supply and demand can also bring inflationary pressures. For example, the disruption felt in transport and in the production of some goods resulting from a strongly globalized economy can bring shortages in the short term and, therefore, an increase in the prices of these products.

And yet the fiscal stimulus to induce consumption and investment, in the Keynesian style.

These may be some of the reasons that make us fear strong inflationary pressure.

But there is also the flip side of the coin, the deflationary pressure side. Mainly because of the debt. Governments will dramatically increase their deficits and companies will take advantage of central banks' flexibility to issue more debt and state-guaranteed credit lines to obtain liquidity.

Business investment has suffered a significant reduction in recent months. Existing liquidity is being channeled into working capital. The lack of investment will further affect the companies' results and their ability to continue in business.

This scenario could lead to a recessionary spiral with company and even state failures, debt write-offs, unemployment and a general decline in asset, product and service prices. This theory is known as debt-deflation (Irving Fisher). If there is inflation, the nominal debt will be consumed in real terms. But with deflation, an already high and even unsustainable debt becomes even more problematic.

Unemployment may also bring negative pressure on inflation via wages (wage contraction). Allied to the fear that is lived, it will certainly provoke a strong reduction in consumption.

In fact, this Financial Times article highlights the increase in the savings rate, as families and individuals prepare for worse days. It simply means postponing consumption and an expectation that prices will be lower in the future. This expectation is felt especially in the consumption of non-essential goods and services and durable goods such as cars, real estate, among others.

The evolution of commodity prices also reflects this disruption between demand and supply and the severity of the recession.

The bond market, often recognized as a good indicator of the state of the economy, reveals fears around deflation, with negative yields in many countries or close to zero, as in the case of the USA.

In essence, long-term interest rates can be read as investors' expectations about the future of the economy. But we should also be careful in this analysis at a time when central banks seem to have taken over the Yield Curve (the yield short of government bond interest rates over their various maturities).

The arguments referred to here are perhaps the most visible. But what we must emphasize is the novelty of a scenario like this. As noted in this article by Trevor Jackson, neither consumers nor economists are used to worrying about deflation.

What we do know is that economic and social theories may be facing a major test by fire. To understand all this dynamic, it may be necessary to develop new policies, new economic models and even new understandings of how consumers and investors and even states and central banks behave. Maybe even a new concept of currency or price stabilization.

The world changed. Economic and monetary theories may also have to change!