Inflation vs. Deflation Dilemma

At the last G8 party, we heard some central bankers quietly hum the lyrics to the song “Exit Strategies.” Some of the groovy dancers, most notably the US Federal Reserve and the European Central Bank, are getting nervous that they might miss a step and take a hard fall with all their anti-recession measures. The funny thing here is that they are sweating because of two different reasons: hyperinflation and deflation.

The US is scared that similar to past recessions; it might see a case of hyperinflation when the economy starts to recover.

The Fed’s money printing is on the same level as Michael Jackson’s (may he rest in peace) #1 albums – mind blowing! Federal Reserve Chairman Ben Bernanke has reduced interest rates to virtually zero and has kept on printing money by the trillions. Its effectiveness in spurring banks to lend, though, is inconclusive at the moment. Combined with the tremendous increase in the government debt, the excess money in the economy and record-low interest rates can lead to rising inflation and put downward pressures on the USD.

The effect of inflation on currencies is pretty straightforward – increasing money supply decreases its face value. Well, the truth is this is normal occurrence and it isn’t necessarily all bad. Money supply naturally increases through time. The problem arises when money supply becomes way too disproportionate to the growth of output of goods and services. This scenario is called hyperinflation. What happens here is that prices increase rapidly at the same time a currency losses its value. It’s really simple when you think about it. The supply of money goes up, causing demand to fall. Eventually, this forces people to re-evaluate the “real” value of the currency relative to goods and services in the market.

Although we haven’t seen a year with double-digit annual inflation in the US for the last 25 years, the country did experience it in the 1910s, 1920s, 1940s, 1970s, and the early 1980s. So, let’s face it, hyperinflation is a very real possibility.

Euro zone, on the other hand, is getting concerned with falling consumer prices. The Euro-zone went into a technical deflation last June 30, 2009. Its annual inflation turned negative for the first time by 0.1% as measured by the consumer price index. The slide in CPI was said to have been caused by the decline in oil prices and the overall slump in demand amid the current recession. The ECB is so much far off from its inflation target of just below 2%. It already slashed its target interest rate to a record low of 1% but it still hasn’t had the desired effect. The bank’s latest move involved an infusion of €442 billion in one-year loans in the banking system. In addition, the bank set aside also €60 billion for its bond purchase program.

Deflation effects are a bit more difficult to grasp. One would think that since the money supply is lower, the value of the currency goes up. Contrary to common belief, lower prices do not necessarily mean that the economy is doing better. When someone is experiencing financial troubles, doesn’t he tighten up his pockets and cut up on spending? I would think so – it’s just “Human Nature.” So, what more if it is happening to an ENTIRE economy? Businesses are forced to lower their prices to stimulate demand, which, in turn, puts downward pressure on productivity. To compensate, businesses reduce costs by cutting wages and firing employees. This puts less money in the pockets of people which lead to another decline in demand for goods and services. The result is a very vicious deflationary spiral.

Much like “Thriller” being at #1 for 37 straight weeks, it is difficult to see which event – hyperinflation or deflation – is more likely to occur. In any case, central banks can’t just tell inflation to “Beat It” and expect to moonwalk through this recession.