Yesterday, I wrote a piece discussing why “It Is Impossible To Replay The 90’s”making the point that we are likely replaying the 1970’s instead. My friend and colleague, Doug Short, emailed me with a valid point suggesting that the inflation of the 70’s, due to the Arab Oil Embargo, was not likely. The real concern, in his opinion, is that we are in an era of stagnation, with the ongoing risk of deflation being the real “wolf at the door.”  To these points, I very much agree.
As a point of clarification, my comments regarding the 70’s was more about the 18-year secular cycle that left investors deeply scarred after three successive bear markets. However, Doug’s point is very interesting, and something that is a much more relevant threat to the current “recovery story” going forward.
As I have discussed previously, the real threat to the Central Banks of the world is“deflation.” Deflation has a deleterious effect on economic growth and once the deflationary cycle takes hold, it is extremely difficult to break. This is why there has been such a focus by Central Banks to create “controllable inflation” through ongoing injections of liquidity via monetary policy. Of course, the reality is that inflation is a function of a variety of factors and there is NO historical evidence that inflation can be contained, or controlled, by monetary policy once it appears.
The chart below is the STA Composite Inflation Index which is simply the average of the Producer Price and Consumer Price Indexes. With inflation still running well below the Fed’s target inflation rate of 2%, despite increasing their balance sheet to over $4 Trillion, the issue of ongoing deflationary pressures is evident.
Note:Â Â It is also important to note that sharp spikes in inflation have also subsequently led to recessionary bouts in the economy. In other words, be careful what you wish for.
First, let’s discuss what comprises inflation. In my view there are three components to inflation: the velocity of money, wage growth and commodity prices.  The velocity of money is how fast money moves through the economy. As money is loaned to businesses to create new products, build plants or expand employment – increased demand leads to higher prices. As employment is increased, and the slack in the labor force is absorbed, the competition for employees causes wages to rise. Higher wages lead to higher demand for goods and services. The increased demand for goods and services leads to higher prices for the raw materials needed to produce those products. In other words, these three components work together in creating inflation. The index below is a composite index of these three factors to show the level of inflationary pressures in the economy.Â
