Inflation, Stagflation, Deflation: What Will Be the Outcome of the Global Monetary and Fiscal Policy Game?

Central bankers fighting a hard landing and the onset of a wage-price spiral are slamming the brakes, while politicians anxious about economic growth and their re-election would floor the accelerator.

What is inflation, and why do we fear it?

Inflation refers to the rise in the general price level of goods and services — in other words, the erosion of the purchasing power of our money.

The opposite concept is deflation, which means a fall in prices. Deflation frequently accompanies a more serious recession.

Deflation must not be confused with disinflation, which refers to a slowdown in the rate of inflation while prices are still rising — for example, when the rate of monetary depreciation falls from 10% to 5% per year compared to the previous year.

Inflation at a level of 2–3% can be considered desirable as a "lubricant" for economic growth — it is no coincidence that most central banks around the world apply a similar inflation target. The 2010s were characterised by inflation being "too low", which led central banks and governments to jointly stimulate the global economy by printing tens of trillions of dollars.

Sustained money printing made lending and investment extremely cheap, and through asset purchase programmes caused brutal capital market asset price inflation — creating bubbles in real estate, bonds and equities.

However, at the end of 2021, inflation escaped from the capital markets and consumer prices also began rising sharply.

From that point on, it became very difficult to contain the ever-accelerating depreciation of money.

Once a wage-price spiral takes hold, the process can become self-reinforcing:

• First companies, then consumers, notice the rise in the general price level

• Companies set higher prices

• Consumers — who typically depend on wages from employers — demand higher pay

• Companies respond with further price increases

• Consumers, alarmed by persistently rising prices, begin panic-buying

• In response, companies — seeing unrelenting demand — raise prices again

• Over time, consumers' money runs out

• As a result, companies' revenues also start to fall

• Companies can no longer afford the increased wage costs

• Mass redundancies begin at companies

• Consumers who have lost their income tighten their belts (this is where we currently stand)

• The resulting collapse in consumption produces a severe recession

• The recession brings price declines, and inflation returns to a healthier level within 1–2 years

Hard landing, soft landing, or a crash?

The scenario described above is what financial market parlance calls a "hard landing" today.

Central banks try to prevent the onset of a severe recessionary (depressionary) wage-price spiral through interest rate hikes, managing the "soft landing" of overheated economies (minimal recession, modest rise in unemployment).

Since global sovereign debt rose to unprecedented levels during the 2010s — and especially between 2020 and 2021, under the radical measures taken against the Covid crisis — they have very little room to manoeuvre.

As an example, financing Hungary's sovereign debt at the currently extra-high interest rates by regional standards costs the Hungarian budget an additional HUF 1,800–2,000 billion per year compared to other countries in the region, placing an enormous additional burden on an already-deficit budget.

The United States, at current interest rate levels, has to pay roughly half of its annual defence budget just in interest servicing to its creditors.

Perhaps even worse than a hard landing from the perspective of monetary depreciation is the scenario where central banks fail to contain inflation while the economy simultaneously stagnates or enters a mild recession — so-called stagflation.

The likelihood of stagflation is increased by the political pressure placed on central banks.

It can take as long as 1.5 to 2 years for central bank measures to begin feeding through into inflation. This is why central bankers are under pressure from governments around the world: governments want to stimulate the economy, and since monetary tightening appears to produce no visible effect on inflation within half an electoral cycle, a dangerous game has been set in motion.

Gold: the last bastion of central bank independence?

The monetary policy versus fiscal policy "game of chicken" has now reached the point where, while central bankers are stamping on the brakes, governments are flooring the accelerator.

This configuration would not merely destroy one car: the global financial and economic system, which has been patched together since 2008, is also rattling under the strain.

We should therefore not be surprised when news arrives each month of a significant bank failure (the background to which we will explore in greater detail in a forthcoming article).

In any case, it appears that one of the last remaining bastions of central bank independence has become the accumulation of physical gold reserves — not without reason did central banks purchase a record 1,136 tonnes of the yellow metal in 2022, a historic high.

Perhaps not coincidentally, since experience shows that gold performs well both in stagflationary and in inflationary and deflationary environments.

The yellow metal performs poorly only during disinflation (which frequently coincides with economic growth and a simultaneous decline in the rate of monetary depreciation).

Most investors hope for the onset of sustained disinflationary processes, but in our view there is little prospect of this now, apart from brief transitional periods.

If we wish to preserve the real value of our savings over the long term, it is worth following the central banks' example as private investors and investing in gold at regular intervals.