Inflation or Deflation: Which Is More Likely?

Last year, I wrote that the current inflation has a fiscal rather than a monetary origin. In other words, we would not have the same inflation in the absence of fiscal stimulus, while we would have the same inflation in the absence of monetary stimulus. For the same reason, I have affirmed and continue to affirm that I view it as unlikely for current inflation rates to begin to consistently exceed two digits, as was the case in the 1970s.

This same pandemic fiscal stimulus has caused serious problems in a variety of markets: sea, land and air freight, electronic products and their components, automobiles, and others, which have added fuel to the inflationary fire. This is the origin of the current inflation we are experiencing, and I will try to make my case with data.

The Current Inflation

In recent months, the rise in the general price level has flattened off. Although in June the annual rate of inflation reached 9% (most recent data), core inflation (which excludes energy and food) already reached its highest point in February (6.4%) and stands at 5.9% in June. In various European countries we witness practically the same tendency, and inflation began to reverse its upward trend.

The main culprit of the fallacies surrounding the current inflation is the quantity theory of money, an erroneous theory, unable to explain changes in the purchasing power of money. Just as the value of Amazon, Inc. does not depend on the number of shares outstanding, the value of our modern-day bank money does not depend on the number of units in circulation.

At any rate, I want to show how the quantity of money (in this case, M2) has changed over the years (concretely, we look at the annual rate of change of the money supply):

Two things are obvious here: the increase in the money supply[1] is not correlated with inflation, not even if we account for possible lags. For many years, inflation has hovered around 2%, even though the increase in the money supply has undergone considerable changes.

For example, from 1983 to 1985 annual inflation barely moved, varying between 3% and 4%, whereas in all previous years the money supply increased at a rate of 10%. From 1992 to 1999, inflation was less than 3% (it reached 1.5% in 1998), but during some years the money supply barely grew (+-0%) whereas in other years it easily exceeded 10%.

Some observers show this graph of M2 in dollars to argue that this time the matter is serious.

However, this type of eye-catching “hockey stick” charts (showing alarming and accelerating growth in the most recent periods) are misleading and give the wrong impression. Few people understand that even with a constant increase of just 1%, eventually any graph becomes exponential. For the same reason, in economics we tend to prefer annual percentage changes or logarithmic graphs to avoid drawing the wrong conclusions.

Sometimes these "hockey stick" charts are not of the money supply, but of the monetary base, which is the monetary aggregate controlled by the central bank. Thus, let us recall the infallible accounting logic that the money supply (M2) is on the liability side of commercial banks, whereas the monetary base is on the asset side of commercial banks . In other words, when the monetary base is increased through central bank policy, it really only increases the quantity of bank assets directly managed by the central bank, rather than “increasing the quantity of money”.

Imagine that we consolidate the balance sheet of the private banks and the balance sheet of the central bank into a single consolidated balance sheet. In this case we would realize that our "money" (bank liabilities in the form of deposits and bills) is backed by assets (different types of credit). What changes is how much of these assets are managed by the central bank versus commercial banks.

Indeed, an early warning sign of a potential collapse of a currency (what Ludwig von Mises called a "katastrophenhausse") is when growth of the monetary base begins to approach and exceed the M2 money supply. In this case, the central bank overtaxes the banking system (that is, it uses its deposits to finance the central bank's own investments). In the case of the German hyperinflation in the 1920s, the monetary base began to increase faster than the money supply of private banks.

The relative increase in the monetary base coincides with the increase in German inflation after the First World War. In 1918, inflation was between 30 and 50%, while in 1919 inflation increased to no less than 100%. Hyperinflation (>1000%) is finally triggered when the Weimar Republic entered into default, at which point the money supply lost much of its backing.

The Quantity Theory Is Wrong and Leads to Mistaken Qualitative “Predictions”

Although the data I showed reveal an absence of an empirical relationship between the money supply and inflation, my position on monetary matters is based on theoretical grounds. The money supply is determined by the general public to the extent that the public is willing to hold units of currency in its possession (this is called the portfolio theory of money).

Just to show the absurd mechanicalness of the quantity theory of money, we can look at the logic of Fisher's exchange rate equation, a fallacious tool often used by quantity theorists.

M x V = P x Y

Where M = the money supply, V = the velocity of money (how many times a unit of money changes hands), P = the prices of goods, and Y = the quantity of goods.

According to the "mechanics" of the quantity theory, an increase in the money supply (M), without an increase in the production of goods (Y), would increase the price of goods (P). When this logic empirically fails to hold, quantitative theorists blame "velocity" (V); the velocity of money is reduced in such a way that the increase in prices that is supposed to have occurred is “cancelled out”.

The problem with all this is that "velocity" is not observable. The only way to "measure" it, is to divide the money supply (M) by the nominal gross domestic product (the equivalent of the right-hand side of Fisher's equation: P x Y). In this way it seems that the monetarists are always right (in fact, they cannot be wrong according to their own logic). Yet, this does not answer the question of who determines “M”: is it determined by banks and banking authorities, or is it determined by the general public?

A very interesting indicator is the money supply (M2) as a percentage of gross domestic product (GDP). Although not generally appreciated as such, with this metric, we can analyze changes in the public's demand for money.

Specifically, we see that the recent, unprecedented fiscal stimulus has increased the demand for money: the money handed out by, chiefly, the Biden Administration has been deposited by people in their bank, at least partially. The money supply does not go up because more money is "printed", but because the demand (portfolio demand) for money increases. Consequently, in the 1990s, the decline of this indicator is not a sign that the Fed "printed less money" but was rather a byproduct of the largest stock market bubble in history. Many people reduced their bank savings and moved their deposits into the stock market, fueling one of the most epic stock market bubbles in history.

What Is the Origin of the Current Inflation?

In the U.S., inflation almost reached double digits. Yet, the current inflation does not find its origin in commodities markets as many might believe. On the contrary, the prices of raw materials are already falling, which has to do with the recession that we are already going through.

In fact, the Bloomberg Commodity Index shows that the price of raw materials is today below the levels recorded in 2005-2008 and in 2010-2012. In both periods, inflation was substantially lower than it is today. Furthermore, in April/May we reached a peak (130) and in the following months the Commodity Index decreased slightly (to 120). We are not really looking at extremely high and rapidly increasing prices of raw materials. Also, for the time being, the trend seems downward rather than upward.

The same trend can be observed in the raw material indices provided by the International Monetary Fund (IMF). The IMF publishes price indices by category. I will show the most relevant price indices in the following graph:

The IMF data reveals that the prices of raw materials (commodities) have generally stopped rising since March 2022. In addition, what largely contributed to the increase in commodity prices has been, specifically, prices of fertilizers and fuel. Curiously, few seem to realize that these prices are at the same level as in 2008, when the rate of inflation was much lower.

In large part, this increase in the prices of raw materials is due to the Russia-Ukraine conflict and the demand for services being substituted by a demand for products (which require transportation and fuel), as well as the restrictions on crude oil production in the United States of the Biden Administration. Pre-pandemic U.S. crude oil production was largely responsible for keeping oil prices in check. Other commodity prices have also been flattening since March or April 2022.

In other words, the current inflationary pressure does not seem to be driven, at least not decisively, by an increase in the prices of raw materials. The prices of raw materials are approximately at the levels of 2008, at a time that inflation rates never reached rates as alarming as those of the present.

The best explanation for the current inflation problem still lies in logistical bottlenecks, as we will see next.

Are the Bottlenecks in International Logistics Improving?

The answer is simple: yes, they are improving, but little by little. In fact, I propose that a large part of the inflationary pressures that we are going through come, mainly, from these logistical problems.

Let us take a look at, for example, the increase (year-on-year) of freight rates (sea and land):

We can observe several things from the data. First, transportation costs have risen at a much faster rate than in any previous year. In other words, while the prices of raw materials are barely at their 2008-level, transport prices have far exceeded those recorded in earlier years. This is the difference between the current high inflation rate and the not as high inflation rate recorded in 2008.

Second, I decided to exclude air freight in the above chart: the price did not go up as much as land or ocean freight. Sea freight is the one that has increased the most (at an annual rate of more than 40%), followed by land freight.

Third, what must not be forgotten under any circumstance is that this increase in the cost of transportation was an act of incompetence on the part of the U.S. Government: a "government failure". A series of ridiculous and unnecessary fiscal stimulus programs ("helicopter" money) created unprecedented distortions in the transportation sector. Few observers actively attribute these unintended (negative) consequences to their true origin: poor government management during the pandemic.

Fourth, the increase in transport prices is flattening out. Moreover, there is a statistical curiosity in this apparently alarming trend. Freight rates have already dropped quite a bit, although the above chart does not show it yet. Let us look at the Drewry World Container Index (which I have used on previous occasions in UFM Market Trends):

Today, the price of moving a container stands at an average of $6,600. The cost per container peaked in 2021 at a level above $10,000 per container. Why does this chart not match the previous one? The first chart is based on year-on-year data; in April the price per container had already dropped to $8,000; however, twelve months earlier, a container cost $5,000. That is, year on year, there is still an increase of 60%. However, in July and August 2022, the current price per container would already be lower than 12 months ago (and therefore the trend in the year-on-year data of the first graph will reverse).

In short, inflation has largely been driven by the container crisis, itself created by the U.S. fiscal stimulus. The data shows that inflationary pressures will soften in the coming months.

Hedging against Inflation: What Assets Should I hold to Protect Myself against Inflation?

First, thinking about “protecting” yourself against inflation when there is already inflation is like bringing ketchup to the table when you have already finished your fries. In financial markets, future expectations are already discounted in current prices. That being the case, a “hedge” (protection) against inflation must be acquired before inflation rears its head. Thus, if you are thinking about hedging against inflation at this point, you are already too late.

Second, financial assets considered “inflation hedges” by some are trading at absurd levels from any valuation standpoint. Prices of these assets (with due exceptions, however few) far exceed their fundamental value (“price is what you pay, value is what you get”).

Ironically, the best investment in this inflationary context appears to be plain-old cash. Interest rates are going up and the "inflation in financial assets" that we carry from previous years is already deflating. There is no point in buying stocks or real estate after years of rising prices that have sparked a tremendous overvaluation.

Why not see it this way? If I hold dollars, I have a return of more than 25% so far this year (see above chart) against the euro. In fact, the dollar reached the (in)famous "euro-dollar parity" earlier this year (1 dollar is worth 1 euro), product of a quite impressive rally. If we compare the dollar with stocks, the dollar has a positive return of more than 20% (and these "returns" will, I argue, continue to go up as long as the stock market continues to decline). Against real estate (in the U.S.), the dollar holds a 20%+ gain, etcetera, etcetera.

The Recession That Is Coming but Already Here

We already know that in the second quarter of 2022 the U.S. economy contracted at an annual rate of 0.9% after a 1.6% contraction in the first half. According to the NBER's definition of a recession, two consecutive quarters of negative growth is a recession. In other words, we are already in a recession in 2022.

We really find ourselves in a recession that had been kicked down the road in 2020, when its effects (the “pain”) were outdone by an unprecedented fiscal stimulus that, rather than “solving” the crisis, merely postponed it. At some point the drug stops producing that so-desired euphoria and that moment came eight months ago.

But we already know how politicians tend to act, and this time around they have suddenly tried to redefine what a recession is. About this and more, you can consult an article by my colleague Daniel Fernández here.

Nonetheless, what a recession implies for inflation is what matters to me here. My conviction is that the "fear of inflation" will be replaced very soon with a fear of a crisis and, consequently, deflationary pressures. If conditions remain unchanged, I would say that in December this year, over the Christmas break, no one will be talking about inflation anymore.

Wage push inflation  and the Labor Market: Can Wages Cause Inflation?

Some economists fear (or feared) a “wage-price spiral” that could continue to fuel inflation. This as a result of a shortage of workers in relation to job vacancies. According to this argument, job offers far exceed the number of potential workers who could cover them. This imbalance causes an increase in wages which, when workers begin to spend their higher wages, produces inflationary pressures.

There are a couple of problems with this thesis. It is true, during the pandemic and, rather, during the fiscal stimulus, many Americans were perfectly comfortable at home. At this stage, companies had a hard time getting workers, and wages rose quite a bit in a relatively short time. The worst competitor for a worker was not another company, but the government that paid workers for remaining idle.

However, this situation has now disappeared. The rise in wages is about the same magnitude now as it was before the pandemic. If there really was a shortage of workers, wages would be rising faster. We can see it in the following graph (change in salaries month by month):

Here we see that the months of the pandemic have really been the anomaly. Wages suddenly jumped 4% in just one month in the U.S, (remember that would be the equivalent of an annualized rate of about 50%, which is extraordinary). However, especially due to the lockdowns (and layoffs), wages fell by more than 1% for two months in a row shortly after (equivalent to an annualized rate of more than -12%, another astonishing number).

In fact, to see if there is a significant difference between the pre-pandemic and post-pandemic period, I have performed a t -test with pre-pandemic and post-pandemic data. After all, in the pre-pandemic period wages increased at a lower rate (for example, 0.30% on average), while in the post-pandemic period they increased at a higher rate (0.39% on average).

However, this difference seems too small to be significant. Using various periods (definitions) “pre-pandemic” and “post-pandemic”, no difference became statistically significant (Wilcoxon t -test, Z = 1.39, p = 0.16)[2]. In other words, the monthly increase in wages is practically the same as before the pandemic and, therefore, should not have a greater impact on inflation. There is no proof that wages rise at different rates in both periods.

Before the pandemic, the labor force represented 63% of the population over 16 years of age (and before the 2008 crisis, 66%). It is currently close to 62%, a drop of about 3 million jobs compared to the pre-pandemic situation. Changes in the workforce are typically slow and gradual, but due to the pandemic, the change has been fast and abrupt.


The fact that the workforce has not even recovered to its pre-pandemic size means that fears of a “wage-price” spiral are overblown. There is more "weakness" in the US labor market than is often admitted. The same can be seen with the US employment rate:

Employment did not fully recover from the pandemic crisis. If there were such a shortage of workers, wouldn't there be less unemployment than before the pandemic? In effect, I propose that the fear of a lack of workers is exaggerated: we should not worry about a “wage-price” spiral that drives inflation in the (near) future.

U.S. Debts: Will the Fed Depreciate the Dollar to Reduce the Country's Debts? Will the Fed Inflate the Debt Away?

Some observers argue that debts in the world are so high that the only way out of the problem is to depreciate the currency in which these debts are denominated. To get straight to the point, this year the total debt of the U.S. government exceeded $30 trillion, with a capital “T” (the debt was just $0.25 trillion at the end of World War II). About $6 trillion is held by the Federal Reserve or, for those who know how to do quick math, 20% of the public debt.

The idea that some propose is that the U.S. will never formally default when it comes time to deal with the excess debt, but that it would simply depreciate the dollar to reduce the debt in real terms. In fact, it was former Federal Reserve Chairman Alan Greenspan who famously claimed that the U.S. could not go bankrupt because “we will always have the option of printing the dollars” to pay off the debt.

If the Fed depreciates the dollar by half, the U.S. debt in real terms is also cut in half. In other words, the public debt is a debt in nominal terms, but the currency is inflated in a way that the public debt is not maintained in real terms. It would be like replacing a cookie someone gave you, but one that is half the original size.

However, there is a problem with this thesis:

To understand why, we first have to understand what financial repression is. To put everything in perspective, let us remember that:

  • U.S. banks have roughly $28 trillion in assets;
  • Americans have roughly $7 trillion in their 401(k) retirement plans;
  • U.S. insurers have roughly $4 trillion in their investment portfolios;
  • And so on.

It is much more realistic for the government to (forcefully) redirect these savings gradually into public debt. In fact, present-day banking regulation (Basel) is already promoting the acquisition of public debt such as the U.S. debt. A savvy politician would know that there are funds available; there is no need for the Fed to create new funds by inflating the currency; it is only necessary to direct the available funds toward the objective.

Japanese politicians have apparently been extremely successful in redirecting the available funds in their country through financial repression. Famed investor Kyle Bass made a bet in 2010 that Japan would default. The country's public debt was simply unsustainable. While it may be true that Japanese government debt was on an unsustainable path, it has been 12 years of relative calm in Tokyo’s markets. Investors continue to trust Kyle Bass with their money, but his investment fund has suffered in the wake of his bad bet against the Japanese government, as Japan did not come anywhere near defaulting on its debt.

The reason is simple: Japan has some of the largest retirement funds in the world. All the institutional money in Japan adds up to $45 billion dollars. Japanese banks hold nearly half: just over $21 trillion. Japan has exercised financial repression to perfection: for years, if not decades, Japanese savers have barely earned interest. In this way, the Japanese government has turned the seemingly unsustainable debt of $12 trillion into something sustainable.

“Printing” the dollars (or yen) is a non-solution of last resort, an act of desperation; it is a path of no return. It is an irreversible death sentence for a currency; it puts the state monopoly over money at risk of the very State that practices it. If political systems were analogies, financial repression is like fascism and "printing" dollars is like socialism. Financial repression is gradualism in its best form; monetizing debt is the nuclear option.

For these reasons, I am a faithful believer in the overconfidence of our present-day politicians of in a policy as Machiavellian as financial repression. I do not believe that public debts will be monetized until politicians have exhausted the financial savings of their citizens.


Despite what some analysts say, we are in a recession and this recession is about to get worse. What's more, the current recession is simply the postponed recession that we suffered (but did not feel) in 2020.

The current inflation is not occurring because raw material prices are spiraling out of control, but is a consequence of the fiscal stimulus and the bottlenecks in the global logistics apparatus that it caused. This year, these bottlenecks began to be resolved. In addition, the fear of a "wage-price" spiral that adds fuel to the fire is unfounded.

For these reasons, inflationary pressures will soon turn into deflationary pressures; the real fear should be of a collapse in asset prices, rather than a runaway increase in consumer prices. Paradoxically, having cash, especially the dollar, is not such a bad option in the midst of the current inflation.

The current increase in the cost of credit is threatening over-indebted governments, companies and households. However, although it may put some governments and companies in particular trouble, it is unlikely that the Fed will "depreciate" the value of the dollar to face the country's unsustainable debts due to an increase in interest rates. The U.S. government is more likely to resort to financial repression: that is, to forcefully redirect money in institutional hands towards investment in public debt, "zombifying" the US economy and reducing its growth prospects, at the expense of American savings and retirements.

Legal notice: the analysis contained in this article is the exclusive work of its author, the assertions made are not necessarily shared nor are they the official position of the Francisco Marroquín University.


[1] In case you are still not convinced and insist on a relationship between the money supply and inflation, following the premises of the quantity theory of money, I suggest this graph courtesy of Ivo C. Nenin (his conclusion: “We show that inflation has exhibited no relationship to broad money growth historically. (…) We also looked at these measures on a lagged basis to account for the possibility that it takes time for money growth to impact inflation. Again, the data shows no relationship between the growth in M2 and lagged inflation.”). There are endless empirical studies on the U.S. case, but almost all of them fail to find a persistent relationship between the money supply and inflation.

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Olav Dirkmaat

Olav Dirkmaat

Olav Dirkmaat is professor in economics at the Business School of Universidad Francisco Marroquín. Before, he was VP at Nxchange and precious metals analyst at GoldRepublic. He has a PhD in Economics from the King Juan Carlos University in Madrid. He has a master in Austrian Economics from the same university, as well as a master in Marketing Strategy from the VU University in Amsterdam. He is also the translator of Human Action of Ludwig von Mises into Dutch. He has a passion for investing, and manages funds for relatives, looking for investment opportunities in markets that are extremely over- or undervalued.

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