The “Deflation Followed by Inflation” Scenario for China and… Well, Everyone Else


It would perhaps be the understatement of the (21st) century that investors find it difficult to reconcile the fact that central banking policies have been “unorthodox” (extremely aggressive) for a very extended period of time with the fact that despite this aggressiveness, inflation problems haven’t surfaced. If anything, governments and central banks have been tacking deflationary forces more so than inflationary ones.

“Fighting” deflation has become the norm to such a degree that as an economist, I always find it uncomfortable to even bring potential inflation problems to the attention of my peers because I know I’ll be on the receiving end of several eyebrow raises. In the proverbial West at least, inflation fears have all but been erased at this point in time and for contrarian reasons if nothing else, perhaps it would be wise to pay adequate attention to the inflation dimension.

Again, problematic inflation, not hyperinflation.

As explained time and time again, a country would have to be remarkably weak to represent a hyperinflation candidate, with all historical examples this author at least can think of fitting that narrative, from post-WW1 Germany which had been weakened by losing the war and a wide range of consequences which derived from that so as to become a hyperinflation candidate to chronically under-developed nations such as Zimbabwe.

Therefore, no, the team does not consider hyperinflation a serious risk factor for China at this point in time, much less so for nations with a more impressive track record of prosperity such as the United States.

But… so what?

This is where my line of thinking and that of many peers diverge. I for one consider it a fundamental mistake to assume that just because the worst case scenario (hyperinflation) is pretty much off the table and just because we haven’t exactly had major inflation concerns in the recent past as far as (moderately and above) developed nations are concerned, the topic of inflation does not warrant our attention.

Is it true that past financial calamities have been deflationary in nature?


Is it true that it has been a long time since the West has been confronted with inflation problems?


But let us please not forget one of the main adages of the investing world: past performance does not guarantee future results, especially if the past performance in question occurred despite unprecedented worldwide central banking measures.

Alan Greenspan lowered interest rates from 6.5% down to just 1% to combat the deflationary effect of the Dot-Com Bubble bursting, yet the market didn’t lose confidence in currencies and central banks to enough of a degree for inflation problems to appear… fair enough.

Moving on, Ben Bernanke was even more aggressive in the aftermath of the Great Recession, with interest rates being lowered all the way down to zero and aside from that, over one trillion dollars being injected into the financial system per year at the height of QE, with other central banks (notably the ECB and Bank of Japan) being even more aggressive. Yet, again, the market didn’t lose confidence in currencies and central banks… once again, fair enough.

However, a worrying pattern seems apparent: the fact that each time, a greater “dose” of monetary aid is required, with central banks needing to become more and more inventive as time passes.

As a thought experiment if nothing else, let us assume that next time around, even more aggressive measures will be employed: negative rates in the US, deeper negative rates in the EU and Japan, China following suit and so on. Furthermore, perhaps “traditional” monetary easing (injecting capital into financial systems) will not be enough and central banks will have to resort to so-called “helicopter money” or in other words, injecting money into the “real” economy.

If the market once again decides that everything is fine, we are good to go for another cycle.

But what if the exact opposite happens?

In that case, in China as well as elsewhere, we will be in for a “deflation followed by inflation” scenario. A rather uncontrolled one, most likely, despite the fact that for the most part, economists tend to “fear” deflation more because past performance has indeed proven that tackling inflation is easier than getting out of a deflationary spiral.

Again, however, what if the market decides to no longer follow the script(s) of the past?

This question is even more so valid in light of the fact that it is difficult to the point of impossible to quantify how much let’s call it pent up energy there is with respect to this phenomenon, with markets minimizing inflation concerns for decades and then all of a sudden perhaps doing the exact opposite.

Who is likely to be affected?

Pretty much everyone, since there aren’t exactly case studies involving proverbial good pupils from a monetary policy perspective… increasing aggressiveness has been the norm across the board.

Of course, there will be hierarchies involved.

For example, China is obviously likely to deal with less of an inflation problem that an average African nation. The same way, the United States is likely to fare better than China as long as the “worldwide reserve currency” narrative for the dollar remains intact and the list could go on and on.

But make no mistake: hyperinflation is most definitely not required to wipe out wealth, high inflation will get the job done just fine.

Furthermore, there are few instances in which timing is more difficult than in “deflation followed by inflation” scenarios due to the likelihood of selling existing assets so as to establish a cash position but not buying back in soon enough and therefore being caught unprepared once the inflationary wave hits.

As such, for most individuals, perhaps holding on to their existing assets or at least their best assets and embracing other strategies so as to build a cash position (anything from generating more income to pruning portfolios and selling the least desirable assets gradually) would be the way to go, especially in light of the fact that building a truly solid portfolio the right way takes time, there is just no way around it.

This undoubtedly sounds remarkably complicated and, unfortunately, it actually is. At the end of the day, a transition from “status quo deflation” like with previous financial calamities to “deflation followed by inflation” inevitably brings about a high degree of uncertainty. Therefore, being thorough and keeping your ear to the ground is a must, with the team gladly putting its services at your disposal so as to be of assistance with precisely such goals.

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