Inflation or Deflation in 2016 and Beyond?

by JDH on December 19, 2015

It’s a simple question, but not a simple answer.  Will the economy next experience inflation, or deflation?

The inflation argument is obvious:  virtually all governments have been printing money like crazy, so if inflation is defined as an increase in the money supply, the obvious result will be inflation.  And, in fact, the press was reporting on Friday that the Inflation rate jumps to 1.4% in November on higher food costs in Canada.  But given the massive amount of money printing, that’s not much of an inflation rate.


In the USA, it would appear, based on this graph from this site, that US inflation peaked at 4.1% prior to the credit crisis, crashed to virtually zero thereafter, and after going back up to 3.0% in 2011 has fallen every year since, and is in the 0.5% range for 2015.

That’s not much inflation.

And it’s not for lack of trying.

Here’s a chart from the Federal Reserve Bank of St. Louis showing the money supply (the “adjusted monetary base”), which not surprisingly went stratospheric when the money printing started after the 2008 credit crisis.


I would suggest that an increase from $800 billion to over $4,000 billion is a big increase in the money supply.

So riddle me this, Batman:

If the money supply went up by 400% between 2008 and 2015, how can the inflation rate be virtually unchanged?

Makes no sense.

The standard explanation is that while the notional money supply may have increased, “money” has not actually increased.  The government has increased the money supply by buying bonds and other securities from banks, so banks have more money, but that money hasn’t made it’s why to the economy.  The average guy on the street didn’t get any of that money that was printed.


So where did the “money” go?

The stock market.

The S&P 500 bottomed around the 700 level after the 2008 credit crisis, and today sits at over 2,000.

That’s an increase of almost 200%, which isn’t as much as the 400% increase in the money supply during that period, but it’s a big chunk of it.  Presumably the other 200% worth of money supply increase can be found in government bonds and other fixed income securities.

It could therefore be surmised that an increase in the money supply does not lead to inflation if the new money does not make it into the economy.  Stock markets may go up, but the wealth effect does not flow down to the real economy, so inflation remains non-existent.

Interest Rates

Does the Fed raising interest rates change anything?

Not really.


If you divide the long-dated Treasury ETF (TLT – iShares 20+ Year Treasury Bond ETF ), by the S&P 500 SPDRs (SPY), you see that Treasury bonds have outperformed stocks this month.


Because during a global deflation, bonds are better than stocks.  Since Treasury yields in the USA are higher than in other developed countries, foreign money is moving to the safety of US bonds.

Short term interest rates may have increased after the Fed decision, but long term yields continue to fall, and that’s good for long dated bonds.



If you want to see deflation in action, take a look at the price of oil.

The price of Brent crude was over $110 in the summer of 2014, and may well see $30 or lower before this correction is over.

And yes, I realize you can make the argument that it’s not deflation that is cratering the price of oil: it’s Saudi Arabia pumping like crazy to crush shale oil in the US, or increases in US production, or whatever.  Those are definitely factors, but there is no way you can make the argument that anything happening in the oil market now is inflationary.


How about another deflationary example: gold.


Again, one could argue that gold’s collapse is not deflationary; it’s just a “supply and demand” thing.

Could be.

But again, a drop from $1,900 to $1,050 is 80%, and that does not appear to be even remotely inflationary.

Which begs the question: is gold dead?  Or is a better question: if we have deflation, does that mean gold is dead?

Inflation or Deflation?

Despite massive money printing, and quantitative easing, and everything else, it is very difficult to make the case for inflation.  I don’t expect oil to go back to $100 any time soon.  The chart of gold looks to be going down, not up.

As for interest rates, they have crept up on the short end, but are still falling on the long end.  That doesn’t appear to be inflationary either.

I will ponder this further, but my tentative action plan for 2016 is as follows:

  • Drastically reduce exposure to gold stocks.  I will keep some as insurance, but given the look of the gold chart, it doesn’t look like a great investment going forward.
  • Increase exposure to the U.S. dollar.  I’m a Canadian.  Earlier this year I moved a lot of the funds in my RRSP and TFSA into U.S. dollar accounts (which is easy to do).  I will continue to do that.  The U.S. dollar is a horrible currency, propped up by nothing, but it’s the best of a bad lot, so that’s where the money goes.
  • On the assumption that interest rates will continue to fall at the long end, I will increase my funds in TLT – iShares 20+ Year Treasury Bond ETF, and use a covered write strategy to increase returns.

I fully expect a hyper inflation to happen, but I suspect it will be a few years in the future, not in 2016, so that’s the plan for now.

Until next week, Merry Christmas, and thanks for reading.