Thread by @LynAldenContact

The next few years are going to test how much deflationary capacity there is in the US and global economy from technology, debt, and demographics to absorb the inflationary increase in broad money.

A thread.

In terms of overall fiscal and monetary policy, including the wartime-like fiscal response that we’ve seen over the past year, the 2020s so far have structural similarities to the 1940s.

Here’s the long-term debt cycle, for example:

During the 1930s, monetary policy hit the limit of what it can do against the prospect of a private debt bubble, and so it was then a massive fiscal response in the 1940s, forced by external factors (the war), that pumped inflation:

Similarly, the 2010s had a partial unwinding of a private debt bubble and a large monetary response, but limited fiscal response.

It wasn’t until the pandemic in 2020 that policymakers brought out the fiscal cannon.

Deflation proponents often point out that the money multiplier (broad money as a multiple of the monetary base) is low right now. That’s true.

However, the only other time it was this low (the 1940s), was actually quite inflationary.

Some people dismiss the 1940s inflationary period as being just transient spikes of inflation due to specific temporary shortages.

And indeed, the inflation of that era came in bursts:

However, the consumer price index never returned to baseline after those inflationary spikes. Those spikes each brought broad prices up to permanently higher levels.

From 1940-1952, the consumer price index went up 90% and stayed there forever.

The reason those 1940s price increases were not transient, is because behind the surface of commodity shortages there was a massive increase in the broad money supply due to fiscal spending, which was effectively monetized.

In other words, if extreme fiscal policy were not occurring in the 1940s, prices would go back to normal after their brief spike from temporary shortages.

The reason they didn’t go back to normal was because the currency itself was devalued.

And that’s not a criticism of policymakers in the era. For investors, there were winners and losers in that scenario depending on what asset classes they were primarily in.

Since it was a currency devaluation, it was cash and bondholders that took the brunt of it.

The deflationary capacity of the current economy is huge, due to automation, software, high debt, wealth concentration, and aging demographics.

And policymakers will be putting that deflationary force to the test.

If they can do a large fiscal burst (spending without associated tax increases), and there is no big inflationary response, then the incentive exists for them to do it again. And again. And again. The only limiter would be obvious inflation.

To the extent that broad money supply goes up a lot and CPI and bond yields stay relatively low, then the money tends to pile into financial assets, since it has to go somewhere. Lately that’s what the situation has been.

In April/May (reported May/June), we’ll get some higher year-over-year CPI prints from low base effects.

After that, broad inflation levels will partly depend on what happens with the next round of fiscal stimulus: if it passes, how big it is, what it targets, etc.

Some of my chart legends didn't update properly. Money multiplier should be rhs here (aka right axis), not lhs. The others are lhs.