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S01E3 Inflations Cousins

In this last part of this section of the mini-series, I want to share some definitions of things we might have seen in some of the episodes but did not explore or explain. It might look like another long one but I used a lot of graphs to illustrate the concepts so it should be a relatively fast read. As always, you can select the graphs to go directly to the source material.

Let’s jump right in.

In the previous episode, we saw how inflation can be driven by both the supply side (a supply shock) and the demand side of the economy and how interest rates can be used to combat inflation. Today we will learn about all the cousins of inflation namely deflation, stagflation, and disinflation.   

Deflation

Technically, deflation is when the inflation rate falls below 0%. When this happens there is a decline in the price level of goods and services which means your purchasing power goes up. Essentially you can buy more goods and services with your money tomorrow than what you can buy with that same amount today. Sounds like a good deal? Not so fast.

While being able to buy more goods and services with your money tomorrow than what you can buy with that same amount today might sound good, it is hardly a good thing in a consumer-driven economy.  Remember the “C” in the GDP equation? We need consumers to participate in the economy for it to grow. When consumers feel prices are going down, they delay their purchases with the hope of being able to buy more in the future than they can today. These falling prices may result in less production. Less production may lead to lower pay and layoffs. Lower pay may result in a drop in demand. And a drop in demand may cause increasingly lower prices. This negative feedback loop can be devastating to an economy and usually goes hand in hand with an increase in unemployment and severe economic downturns.

A lesson from the land of the rising sun.

When Back to the Future was released in 1985, Japan’s economy was 32% the size of the U.S economy but growing at a fast pace.

By the time Batman Forever was released in 1995, Japan’s economy had grown to over 72% the size of the U.S and was by all forecasts projected to overtake the U.S as the world economic leader.

As we now know, that never came to pass as the country spent the next decades struggling with periods of deflation.

In the year 1 B.C (1 year Before Covid), Japan’s GDP was still lower than it was in 1995

Inflation can be fought by interest rates – as we saw in the last episode – but how do you combat deflation? How do you convince people to spend and contribute to the economy when they believe prices will be lower in the future? Japan is yet to come up with a compelling solution. The lesson: avoid falling into a deflationary spiral to begin with.

We have seen our periods of deflation in North America too, but since those were recession-driven – recessions place downward pressure on prices – those periods were short-lived.

While deflation is generally not a good thing, we also have benefitted from deflation in certain areas because of productivity and technological improvements. The TV example from the last episode is a prime example, and you can also include computers, cameras, toys, and certain healthcare advances to name a few in that list.  

Stagflation

Stagflation got its name from combining stagnation and inflation to describe an economy in which inflation is increasing and economic growth is decreasing or even negative (a recession). You might have heard this term used in the news more often lately as they try to compare today’s economic environment with those in the 70s. A quick fact to impress your friends: the term was first used in the 1960s by a politician name Lain Macleod while addressing the house of commons in the United Kingdom – you can thank me later.

Stagflation is a weird scenario because seeing prices increase while unemployment is rising, and an economy is shrinking does not make economic sense.  It can happen when there is an increase in input cost while an economy is falling. If for example, like in the 70s, there is an oil price shock while the economy is shrinking, prices of gas and other products will rise even with unemployment increasing and demand falling.

Are these the 70’s all over again? There are several reasons why what we are seeing today is not like the economic environment of the 70s – not in the least bit. Here are a couple of examples for your consideration from Russell Investments:

Today’s surge in oil prices is different

Geopolitical tensions also contributed to dual-energy shocks, in 1974 and 1979, with yearly changes in oil prices rising by over 300% and 180%, respectively, just five years apart. And although oil prices have surged today from their pandemic lows, as the chart below shows, oil prices have risen by similar magnitudes in the past—and the current surge pales in comparison to the dramatic rise seen in 1974. Another factor to consider is the advancement of technology as it relates to extraction. As prices increase, more technologies – like fracking – become economically viable and as a result, over time, supply increases and prices come down. It appears that the best way to solve the problem of high commodity prices in today’s environment is high commodity prices.

Source: Refinitiv DataStream, Russell Investments. Annual data as of 2020.

Population Growth

A growing population increases demand for products and as such can set the stage for higher inflation – especially if inflation is already prevalent. As you can see in the graph below, increases in the population growth rate often correspond with an increase in inflation. Today’s population growth rate is about half that of the 70s and it does not seem likely – based on current social and immigration trends – to change materially in the coming years.

Source: Refinitiv DataStream, Russell Investments. Annual data as of 2020.

Global Trade

Global trade has done wonders in the fight against inflation since the 70s. As you can see below, international trade increased from 25% of global GDP to 55% since the 70s. And while it is not likely to expand significantly from here, it is also unlikely to go back to the 70s level.

Source: Refinitiv DataStream, Russell Investments. Annual data as of 2020.

Supply chain problems

Supply chains have been a big contributor to inflation over the past year (more graphs on this later) and while they are not fully functional or caught up yet to pre-pandemic levels, we continue to see an improvement since the beginning of the year.

Source: Refinitiv DataStream, Russell Investments. Annual data as of 2020.

While there are some similarities to the 70s i.e., higher oil prices, there are more differences and opportunities to bring inflation down while also not bringing the economy to its knees.

Disinflation

Disinflation sounds like deflation, but they are very different. We want disinflation at this point – it will be a good thing. Disinflation is the slowing in the pace of inflation. As an example, if inflation drops from 7% to 4%, that would be considered disinflation.

That is it.

What a journey these episodes have been. If you followed them closely you should now have a full toolset to understand the economy on a whole other level – well above the average Canadian. Here are the things we discussed:

  1. GDP is measured through the formula C + I + G + ( X – M )
    •  C = total spending by consumers.
    •  I = total investment by businesses.
    •  G = total spending by government
    •  X = the total exports and
    • M = the total imports (X-M = Net Exports)
  2. In most economies, real output (GDP) follows a rising trend determined by the supply side of the economy.
  3. In the short run, fluctuations around the trend growth rate of GDP are dominated by demand side forces.
  4. Fluctuations around trend growth may be substantial (and costly) because economies, by themselves, don’t return to full speed quickly.  
  5. Fiscal and monetary policy can, in theory, be used as discretionary instruments to adjust and stabilize fluctuations so the economy returns to its trend growth path.
  6. The drivers of inflation – both from the supply and demand side of the economy.
  7. How interest rates affect inflation.
  8. The difference between inflation, deflation, stagflation, and disinflation.

You almost deserve an economics degree with all this information – well done.

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