The Inflation vs Deflation Debate

Summary: No one can predict whether this bout of inflation that the world is experiencing is transitory or not. It is also difficult to argue against the long term, persistent deflationary forces at work from immense technological innovation. Nonetheless, at the very minimum, the past 10 months have been an academic’s delight as heavy weights like El-Erian, Summers, Dalio, Dorsey and Rosenberg, Cathy Wood, and probably the entire Fed team or the Democratic economic team take the seats on the debate podium. But more importantly, each of us should be playing out this debate in our own minds. This article attempts to provide some food for thought. You will see that, in summary, there exist powerful forces, both inflationary and deflationary in today’s context. And the economic outcomes will finally be dictated by the forces that come out on top. No one can predict what will happen with any amount of accuracy. But one thing is for sure, ignorance will prove costly. Stay on top of your game.

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What is stagflation? The word stagflation was apparently coined by the UK Tory politician Iain MacLeod in 1965. The word is a combination of 2 half words – “Stag” from the word Stagnant and “flation” from the word Inflation. In simple terms, stagflation is used to describe a period or an occurrence of low or stagnant economic growth and high inflation, coupled with high unemployment. In short, the worst of both worlds.

Here is an interesting fact. Interest in this word in Germany (as evidenced by data on number of google searches) has reached a 13 year peak! Probably, it is more relevant psychologically or closer to the German hearts given the grinding experience of the Weimar Republic in history. But generally, interest in or attentiveness to this word is up to a multi-year high in most countries, including the UK. (

Milton Friedman’s famous quote “Inflation is always and everywhere a monetary phenomenon” is so widely known and used that it has probably become a cliché now. I even get my 5 year old daughter to repeat it after me – just for fun! The quantity theory of money had its day in the sun in the 1970s and post the 1970s stagflation. The monetarists argued that controlling the quantity of money in the economic system was necessary for a stable economy and prevent erratic market behavior. Paul Volcker put the theory to test and successfully brought down stubbornly high inflation, bringing down curtains on one of the most difficult eras for US central bankers. In the years that followed, the quantity theory money lost relevance. Monetary policy today is firmly guided by the tool of setting prices in the economy instead of controlling the supply of money in the economy. Post the 2008-09 GFC, monetary policy has generally been kept accommodative, rates have been forced lower, reserves and central bank balance sheets have been expanded. And yet, inflation has been conspicuously absent, at least by traditional definitions. The virus induced recession has turned things on its head and created nuances to this inflation / deflation debate which, at the minimum, merit academic haggling and laying down cases for each side of the debate.

In this article, I will highlight 3-4 key aspects to consider, as you think about each side of the debate. Ultimately, it is for you to decide which camp you are in.

The Oh-Beware-Stagflation-is-Coming Camp

  1. Huge fiscal spending in addition to accommodative monetary policy

The political will worldwide, to counter the recessionary forces brought about by the pandemic has been colossal. Every country’s government dug deep into its purse and beyond to spend and support the economy. But none more than the United States of America.

Source: Database of Fiscal Policy Response to Covid 19 – IMF

The government of the day during the 2008 financial crisis had also pulled fiscal levers to address the economic risks stemming from the GFC. But the fiscal spend then pales in comparison to what has been spent over the last 2 years. See graph below.


2. Helicopter money and marginal propensity to consume

One of the key theories advocated to explain the lack of inflation, despite the accommodative monetary policies and endless QEs of the past decade has been that inflationary effects were mostly found in asset prices and the resultant wealth increase was mostly in the hands of the rich, and not the working class. In general, the marginal propensity to consume is lower for the wealthy. That’s just a fancy way of saying that the rich tend to save more of their income and the less wealthy tend to consume more of their income. Which understandably is driven by basic needs. This time though, money found its way to the hands of the public, thanks to the handouts, transfers, credits, that have dominated the fiscal response. The chart below is not broken down by institutional deposits and retail deposits or even by retail deposit type. Yet, it provides a good idea of the quantum of deposit increase on the back of fiscal spend. (If you want to read commentary on this, visit the FDIC website)

Source: FDIC

These helicopter handouts have truly been unprecedented, and the below chart illustrates the sizeable impact of the different rounds of Covid stimulus bills and economic impact payments to households. This is real money in the hands of real people with real and material needs. Once again, the key point to note is that the size of increase in personal income on account of these transfers is much larger than what was experienced during the 2008-09 crisis.

Personal Income Increase during the 2008-09 Crisis
Personal Income Increase during the 2020-21 Crisis

3. Labor’s bargaining strength

It’s popular belief that the decline of labor and the tipping of scales in favor of corporate America started with the Raegan era and the famous or infamous incident of Raegan firing striking air traffic controllers in 1981 and barring them from working for the Federal Government. Popular theories aside, it commonly observed and agreed that labor wages have remained relatively stagnant, especially when compared to return on capital over the last 40 years. However, phrases like the “Resurgence of Labor”, “the Great Resignation” are starting to gather more soundbites. The pandemic has upended people’s behaviors and preferences in an unforeseen manner. In August 2021, 4.3 million workers quit their jobs, presumably because they can find better paying opportunities elsewhere. By one account, there are more than 10mn job openings in the US and yet more than 7mn people remain unemployed. The trauma and frustrations of a long drawn, movement restrictions filled 2 years of the pandemic are making people sit up and think what do they really want to do with their lives. In recent months, there have been quite a few news reports of labor strikes or workers voting for a potential strike. While the numbers might still not be large enough to make an immediate macroeconomic impact, the number of occurrences have been noteworthy (To list down a few – International Alliance of Theatrical Stage Employees, United Auto Workers walked off the job at fourteen John Deere plants, fourteen hundred workers at the cereal giant Kellogg walked off the job to protest the company’s proposed two-tier pay system, twenty-four thousand employees of Kaiser Permanente, one of the major insurers and hospital chains, voted to authorize a strike).

Whether this a structural shift and a permanent increase in labor’s bargaining position is difficult to state at this point. Headline wage numbers have been increasing though. Wage growth has also prominently started to feature in the forward guidance of companies.

4. Inflation expectations

Finally, IMHO, it really depends on inflation expectations and how firmly or loosely are they anchored. This is the holy grail of central banking. That tight grip over inflation that Central Bankers guard so zealously and the prospect of runaway inflation that gives them nightmares. A Central Bank will do all it takes to ensure that the market and the public does not lose the confidence that it will keep inflation under control. But the day it gets de-anchored, it becomes a self-fulfilling phenomenon. You need to ask yourself – have you started advancing your spending plans in the fear that prices might rise soon? Are you advancing your purchase of the new iphone, the new dining table, the new car or even that leisure experience because you fear prices will rise in the near term? From an economic data perspective, you can keep track of the 5 year break even inflation rate. It’s the spike at the top right corner of the chart that really matters.

The I-Will-Skip-Meals-To-Buy-ARK-Invest Camp

  1. Technological forces

Technological innovation is immensely deflationary. And it is persistent, not transitory. And there are no two ways about it. Technological changes have been happening over the past few decades, but the pandemic has accelerated the shift. Technological innovation allows for a more intense and efficient use of resources, thereby driving prices down – Airbnb, which found an innovative and path breaking way of utilizing the massive stock of “shelter” inventory. Or Uber and Lyft which provided a way to utilize the surplus capacity in the form of stock of cars or available “seatmiles”.  If you are looking for services to help manage a website, admin support, accounting support, sales or marketing support, online solutions like Upwork or Fiverr provide you the opportunity to hire the best talent at the cheapest cost. This is just the tip of the iceberg and the possibilities are endless with newer improvements in computing, artificial intelligence, robotics, etc. In this context, supplier or labor pricing power stands significantly reduced and it is practically impossible to reverse these long-term, technology driven trends.

2. Velocity of money

Milton Friedman and his fellow monetarists primarily viewed inflation and growth through the lens of money quantity. And it served very well in its day to tackle the high inflation of the 1970s. The legendary Paul Volcker, in keeping with monetary theory, swallowed the bitter political pill and effectively ground the US economy to a halt and brought down the stubbornly high inflation rate. The quantity theory of money, in very simple terms, states that the money supply in the economy times the rate at which money changes hands every year (called velocity of money) equals the nominal GDP of the economy. The backdrop to this theory worked very well because up until the 1970s, velocity of money was fairly constant. Hence, increasing the quantity of money had the effect of spurring expenditure, growth and consequently inflation. See the first graph below.

Velocity of M2 – 1960 to 1970

This relationship has unarguably broken down in recent decades, as evidenced by the graph below. The stock of money, both base money and M2, has growth significantly in the last decade. Yet inflation has been absent, at least per traditional definitions.

Velocity of M2 – 1997 to 2021

In short, while money has flooded countries, it just hasn’t moved enough among the constituents of the economy to generate meaningful consumer inflation.

3. Bank lending and creation of new money

Commercial Bank deposits are created when Banks lend. Contrary to popular perception and the way it has historically been taught in school textbooks, a Commercial Bank does not create new money by first taking in deposits, placing a portion in reserve with the Central Bank and lending the balance. It is quite the other way round, where Commercial Banks find profitable opportunities to lend and create a deposit a.k.a New Money in the process of lending. One of the strongest deflationary forces at work, especially in the post GFC and tighter bank regulation world, has been the anemic growth of business lending. Candidly, this assertion does not require a lot of data (even though it has been provided below). But from our personal experiences, we know that it is much easier to obtain a bank mortgage loan to buy house than it is to obtain one to start a new business. The chart below shows total deposit and total loans and leases growth in the US since right before the 2008 financial crisis. The story is visibly clear. And this chart does not factor in the important difference between loans and leases provided for purchasing an asset like a house and those provided to start a new business and generate employment. Needless to say, capital market borrowing has been robust in the last decade as evidenced by the record number of new issues. But borrowing in the capital markets does not create new money. Only Commercial Banks have that power.

4. What about Oil Prices?

It is true that an increase in energy costs makes its way into the pricing structure for goods and services for final consumption. Similar to the oil shocks of the 1970s, oil prices have risen swiftly and significantly this year. There are some other uncanny similarities as well. For instance, heavy expenditures related to the Vietnam War then and the continuing conflicts over the past decade in the Middle East now. Industrial commodity prices had also risen significantly prior to the oil shock of 1973. However, the quantum of oil price increase between the 1970s scenario and now differs vastly. The spot price of crude oil had jumped by over 210% from July 1973 to October 1974. And then jumped by another 165% from Jan 1979 to April 1980. That’s close to a 10-fold increase in crude price over a decade. While prices have risen in the last 12 months, the rise is nowhere close to the 1970s experience. This comparison is stated in nominal terms. In inflation adjusted terms, the increase in the price of oil is even more underwhelming. If record Brent prices in 2008 are restated at the purchasing power of the dollar in 2021, prices peaked at more than $180 per barrel (Source – Reuters). The chart below is quite self-explanatory.

Price of Crude – Inflation Adjusted


In summary, there exist powerful forces, both inflationary and deflationary in today’s context. And the economic outcomes will finally be dictated by the forces that come out on top. No one can predict what will happen with any amount of accuracy. But one thing is for sure, ignorance will prove costly. Stay on top of your game.

Register for regular updates, new articles, and interesting video content on

Happy investing!