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***While inflationists and deflationists can support their arguments with select data about money supply and interest rates, the most important factor to watch, according to Moses Kim, is the dollar exchange rate. A loss in confidence in a currency can happen very quickly, as the Euro has demonstrated, and this can lead to rapid inflation. See the following post from Expected Returns.

The inflation vs deflation debate is one fraught with biases, misnomers, and rigid positions. What I’ve noticed is that both inflationists and deflationists selectively handpick data to support their respective positions. This is fine and dandy if your goal is to win an argument; but if you want to win as an investor, you must unemotionally interpret data.

If I had to, I could make a convincing argument in either direction since we are seeing both inflationary and deflationary forces. I don’t believe there is much debate on this point. However, the successful investor doesn’t tell you what is happening right now. The successful investor is constantly trying to foresee future events using a Bayesian approach to investing, incorporating data on an ongoing basis to adjust forecasts if necessary.

Interest Rates

At the very core of the inflation vs deflation debate are interest rates. Unfortunately, most people misunderstand the relationship between interest rates and inflation.

Interest rates are driven primarily by inflation expectations and default risk. This implies that interest rates can both rise and fall with good reason in both inflationary and deflationary environments. In other words, the relationship between interest rates and inflation isn’t so simple as to say lower interest rates equals higher inflation or vice versa.

Inflationists will tell you that low interest rates are inherently inflationary. At the very core of this argument is the fact that low interest rates will induce borrowing, and by extension, speculation. To support their argument, they will show you a negatively correlated inflation and interest rate chart like this:



Deflationists will tell you low interest rates not only evidence deflation, but muted inflation expectations. To support their argument, they will show you a positively correlated chart like this:



As you can see, both deflationists and inflationist can point to statistically and historically valid data to support their respective arguments. Unfortunately, both sides are guilty of showing just a snippet of the overall picture. The inflation vs deflation debate is far more complex and goes well beyond just interest rates.

Money Supply and Inflation

Let me preface the following statement by saying I lean heavily towards the Austrian camp. However, there isn’t a strong correlation between money supply and inflation in the short-term. This is key to understanding why a hyperinflationary collapse didn’t materialize last year when money supply went through the roof.

In the early stages of inflation, money supply often outpaces inflation by many multiples. This was the situation in the Weimar Republic before their hyperinflationary collapse. The following charts taken from Constantino Bresciani-Turronis seminal text about the Weimar hyperinflation, “The Economics of Inflation”, makes this relationship clear.






Notice that in the early stages of inflation, money supply outpaced domestic prices, import prices, and the dollar exchange rate. However, the situation in the Weimar Republic quickly deteriorated to the point where money supply, domestic prices, import prices, and the dollar exchange rate had a near perfect correlation. The public lost confidence in their currency and prices essentially “caught up” to money supply.

In 2009, Ben Bernanke cranked up the printing presses and the money supply expanded at an unprecedented clip, yet there was no hyperinflation. Inflationary forces were certainly concentrated in certain sectors, such as stocks, but on a broad scale, inflation was muted.



Recently the trend in money supply has reversed. According to John Williams at shadowstats.com, M3 is contracting at the fastest rate on record. This is an apparent victory for the deflationists, right?

Not so fast.

Dollar Exchange Rate

I believe the number one driving force of inflation moving forward will be the dollar exchange rate; and I believe the the loss of confidence in the monetary system as currently structured will lead the dollar down. History shows that the truly monster currency moves are driven by public confidence.

Remember, it was only a year ago that the Euro was the safe haven currency of choice for investors. The recent collapse in the Euro is correctly blamed on the debt crisis in the PIIG nations. However, the debt problems in the Eurozone were well known for years. The only thing that changed was perception.

Perception is the only thing propping up the U.S. dollar. Europeans thought they could waddle through their debt problems unscathed until, well, they couldn’t. Americans are similarly inflicted with the head-in-the-sand disease that ignores large-scale funding problems similar to those seen in Greece. The dollar will continue to profit from safe haven capital flows until, well, it doesn’t.

Swings in the dollar, and by extension inflation, will be sudden and dramatic, mirroring the confidence of investors. It will therefore benefit people in both the inflation and deflation camps to rethink their respective false assumptions. The fundamentals for dollar weakness have been in place for some time; it is now time for the market to recognize it.

This post has been republished from Moses Kim’s blog, Expected Returns.

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***Mark Thoma and Paul Krugman describe why they disagree with fellow economist Raghuram Rajan’s argument for raising interest rates. Rajan calls the rates “unnaturally low” but Krugman questions the idea that it is inherently bad for money to be cheap and Thoma questions the assumption that low rates have more costs than benefits. See the following post from Economist’s View.


Paul Krugman responds to Raghuram Rajan’s latest defense of his view that the Fed should raise the target interest rate:

Strange Arguments For Higher Rates, by Paul Krugman: So Raghuram Rajan has posted a further explanation of his case for raising interest rates in the face of very high unemployment, presumably a response to Mark Thoma. It’s good to see Rajan put his cards on the table — but what he says only further confirms my sense that we’re talking about some kind of psychological desire to be tough…

Rajan’s argument boils down to two assertions:

1. Raising rates a bit wouldn’t significantly deter investment.

2. “Unnaturally low” interest rates are distorting asset prices.

The first thing to say about these two assertions is that they are essentially contradictory. If the difference between current rates and the rates Rajan wants is trivial — just a wafer thin mint — how can that same difference be leading to a major distortion in financial markets? Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators? And actually, don’t asset prices themselves matter for real investment?

It might be worth noting, in this context, that just because the interest rate on safe bonds is near zero, that doesn’t mean that people making risky investments can borrow at near-zero rates.

Beyond all that, what does Rajan mean by “unnaturally low” rates? What makes them unnatural?

My take on the current economic situation is quite simple… Right now, we clearly don’t have enough demand to make full use of the economy’s productive capacity. This means that the real interest rate is too high. And so the “natural” thing is for the real rate to fall. Yes, that would mean a negative real rate. So?

The trouble is that getting that negative real rate isn’t easy, because the nominal rate can’t go below zero, and there’s no easy way to create expected inflation. If you ask what would happen if prices were completely flexible, the answer, as I figured out long ago, is that prices would fall so far now that people would expect them to rise in the future, creating expected inflation. Bur prices aren’t that flexible, which is why we turn to quantitative easing, fiscal policy, and more.

Surely, though, we want to get rates as close to their appropriate level as possible — which means a zero nominal rate. There’s nothing “unnatural” about it. On the contrary, the “natural rate of interest”, as Wicksell defined it, is clearly negative right now.

So why does Rajan feel that there must be something wrong with low rates (and he’s not alone)? I think his language, with its odd moral tone, is the giveaway: it’s the sense that economic policy is supposed to involve being tough on people, not giving money away cheap.

I actually understand the seductiveness of that posture; I can sort of understand how economists succumb to it. But right now, with the world desperately in need of clear thinking, is no time to give in to the subtle allure of inflicting economic pain.

I had the same response. If raising rates doesn’t change investment, how does raising rates choke off risky (and distorted) financial investment which ultimately depends upon real investment activity?

(There is also an argument that high rates, not low rates, cause an increase in the proportion of investors taking high risks. When rates are high, only the riskiest, highest expected return projects will have a chance of being profitable, so these are the only projects that are pursued. In this case higher rates, not lower rates, lead to an increase in the fraction of risky investment. This is where Krugman’s point that the interest rates people making risky investments actually face are not zero, and increasing these rates by another 2 to 2.5 percent, as recommended, will raise them even higher and potentially induce more risk-taking behavior. This doesn’t directly overturn the argument the arguments Rajan is making, but it is a potential countervailing force.)

Let me also address this part of Raghu Rajan’s response, which I assume is directed at the title and content of this post (”The Fed Should Raise Rates Because Brazil has Low Unemployment?”):

If the Federal Reserve were to accept the responsibilities of its role as central banker to much of the world, it would have to admit that its policy rates are too accommodative for the world as a whole. Does the Fed have responsibility to help the world while hurting its own economy (or as one commentator put it, am I advocating that the U.S. raise rates because Brazil is overheating)? Of course not! But when the benefits to its own economy are dubious, it should also give some thought to the global effects of its policies. For eventually, the consequences of its policies will come back to haunt it if they precipitate crises elsewhere.

That the benefits of low rates are dubious is an assertion, not a demonstrated fact. Rajan’s post attempts to make the case that low rates have costs that exceed the benefits, i.e. that the net benefits are “dubious,” but here he is assuming he has already proven his case. So, yes, if you assume that there is no cost to raising rates (which is what the debate is all about, so clearly I disagree with this assumption), assume that low rates will cause a crisis in Brazil or somewhere else (the argument is that these countries need to raise rates, but low rates in the US prevent them from doing so), and assume that a crisis in one of these countries will cause a crisis in the US (or at least significant troubles), then yes, I suppose we should take this into account. But it takes quite a few “dubious” assumptions to come to this conclusion, the contradictory “it won’t change investment” among them, so I am not at all convinced by this argument.

This post has been republished from Mark Thoma’s blog, Economist’s View.

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