Inflation or Deflation: Who’s Really in Control?

Inflation vs. Deflation: The Battle for Economic Dominance

Updated July 29, 2024

“The four most dangerous words in investing: ‘this time it’s different.’” — Sir John Templeton

Inflation may pose challenges in the short term, but the long-term outlook favours deflation primarily due to technological advancements. This essay examines historical inflation predictions, revealing a pattern of fear-mongering that often fails to materialize.

The Cry of Wolf: A History of Failed Predictions

Consider these past headlines that stoked fear of inflation:

– 2009: “Inflation Scare: Crazy but Real” – American Enterprise Institute
– 2010: “My Inflation Nightmare” – The Atlantic Monthly
– 2011: “A high price to pay” – The Financial Times
– 2016: “Inflation will be the biggest economic story in 2016” – Business Insider
– 2020: “The Coronavirus Economy Will Bring Inflation” – National Review

These predictions consistently failed to materialize, suggesting that experts often misinterpret economic signals.

Redefining Inflation in the Modern Era

Traditionally, inflation refers to an increase in the money supply. However, the term has evolved to describe rising prices, a common symptom. This essay focuses on the latter definition while acknowledging its limitations.

The Myth of Hyperinflation

Historical data, such as the 25-year and 107-year Consumer Price Index (CPI) charts, reveal a stable trajectory, disproving rampant inflation theories. The CPI has remained relatively stable, contradicting hyperinflation fears.

European Inflation: A Closer Look

Europe’s inflation averaged 0.9% over the past five years, with Germany experiencing negative inflation in late 2020. Despite recent upward trends, the overall impact remains minimal. For instance, Germany’s inflation rise in 2021 follows a VAT holiday rollback, a temporary adjustment.

Technology: The Great Deflator

Technological advancements, particularly AI, exert significant deflationary pressure. Innovations lead to efficiency and cost reduction, challenging traditional inflation models. As Ray Kurzweil, a renowned futurist, predicts, AI’s impact on productivity could lead to sustained deflationary pressures in various sectors.

107-year chart of the CPI

This chart effectively puts an end to the Rubbish theory of inflation. The CPI index would have to hit ten before we would start to pay close attention to it. Today, we have a generation of spoilt brats, including the old and the young. Everyone has been brainwashed into believing that any crap published in a respectable journal qualifies as the “word of God”. Less than 10% of the populace attempts to seek the truth. Many of what qualifies as science today should be classified as Pseudoscience. Secondly, most of today’s experts would have been classified as mental retards a few decades ago.

Mass Psychology and Market Behavior: The Invisible Hand of Emotion

John Maynard Keynes’ observation that “the market can remain irrational longer than you can remain solvent” underscores a crucial aspect of economic trends: the power of mass psychology. Often overlooked in traditional financial models, this phenomenon is pivotal in shaping market behaviours and outcomes.

The Herd Mentality in Action

Cognitive biases, particularly confirmation and herd mentality, frequently override fundamental economic factors driving market behaviour. Investors seek information that aligns with their beliefs about inflation, often disregarding contradictory evidence. This selective perception can lead to self-fulfilling prophecies in market movements.

Consider the dot-com bubble of the late 1990s. Despite clear signs of overvaluation, investors continued to pour money into tech stocks, driven by a collective belief in the “new economy.” This herd mentality pushed stock prices to unsustainable levels, eventually leading to a market crash.

The Role of Media in Shaping Perceptions

Media coverage plays a significant role in amplifying mass psychological effects. The constant stream of headlines about inflation fears can create a feedback loop, where investor anxiety leads to actions that may contribute to inflationary pressures.

For example, during the 2008 financial crisis, media reports of bank runs led to actual bank runs in some cases, as people rushed to withdraw their money based on fear rather than the actual financial health of the institutions.

Cognitive Biases in Economic Decision-Making

1. Availability Heuristic: Investors often overestimate the probability of easily recalled events, such as recent market crashes or periods of high inflation.

2. Recency Bias: There’s a tendency to place too much importance on the most recent data or experiences. This can lead to overreactions to short-term market fluctuations.

3. Loss Aversion: The pain of losing is psychologically about twice as powerful as the pleasure of gaining. This can lead to irrational holding of losing positions or panic selling during market downturns.

Case Study: The 2021 Meme Stock Phenomenon

The GameStop stock surge in early 2021 provides a striking example of mass psychology in action. Social media influence, anti-establishment sentiment, and herd behaviour led to an unprecedented surge in the stock price, disconnected from the company’s fundamental value.

This event demonstrated how collective behaviour, amplified by modern communication channels, can create significant market distortions. It also highlighted the power of narrative over traditional financial metrics in driving investment decisions.

Countering Mass Psychology: The Contrarian Approach

Successful investors often adopt a contrarian stance against the prevailing market sentiment. Warren Buffett’s famous advice to “be fearful when others are greedy and greedy when others are fearful” encapsulates this approach.

For instance, during the 2008 financial crisis, while most investors were panic-selling, contrarian investors who bought into quality companies at depressed prices saw significant gains in the subsequent recovery.

Overcoming Panic Selling: The Power of Technical Analysis

Technical analysis, a method of evaluating securities by analyzing statistics generated by market activity, can be a powerful tool for investors navigating periods of market panic. Charles Dow, the father of technical analysis, emphasized the importance of trend identification in market movements.

By studying price patterns and market trends, investors can make more informed decisions, potentially avoiding the pitfalls of panic selling during inflationary scares. Here’s how technical analysis can be applied:

Support and Resistance Levels

Identifying key support and resistance levels can help investors understand where prices might stabilize or reverse. These levels can provide crucial insights into potential buying opportunities during market panics.

Moving Averages

Moving averages smooth out price data to create a single flowing line, making it easier to identify the overall trend. The 50-day and 200-day moving averages are particularly popular among traders for identifying long-term trends and potential reversal points.

Volume Analysis

Volume often precedes price movements. A spike in volume during a sell-off, followed by decreasing volume as prices stabilize, can signal that panic selling is subsiding.

Relative Strength Index (RSI)

The RSI is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions. During market panics, shallow RSI readings can indicate potential buying opportunities.

Case Study: 2020 Market Crash

During the March 2020 market crash, technical analysts noted that vital technical indicators such as the RSI reached extremely oversold levels not seen since the 2008 financial crisis despite the rapid decline. This, combined with bullish divergences on longer-term charts, provided early signals of a potential market bottom, helping some investors avoid panic selling and even identify buying opportunities.

By incorporating these technical analysis tools, investors can gain a more objective view of market conditions, helping them make rational decisions even in the face of widespread panic. However, it’s important to note that technical analysis should be used with fundamental analysis and an understanding of broader economic conditions for the most comprehensive approach to investing.

The Value of Fear in Investing

Warren Buffett’s famous advice to “be fearful when others are greedy and greedy when others are fearful” highlights the contrarian approach to market psychology. Fear, when properly harnessed, can be a valuable tool for investors.

During heightened inflation fears, rational investors can find opportunities in oversold assets, potentially benefiting from market overreactions.

Real-World Examples: Commodity Prices and Inflation

The 25-year chart of Nickel prices serves as a case study of the complex relationship between commodity prices and inflation. Despite a significant increase in money supply over the past decades, Nickel prices have not shown a corresponding rise, challenging simplistic inflation narratives.

The Velocity of Money: A Key Indicator

The velocity of money, currently at a 60-year low, is a critical factor in understanding the dynamics of inflation and deflation. As long as this metric remains depressed, deflationary forces will likely dominate the economic landscape. It’s essential to recognize that inflation and deflation can coexist. While prices of technology-based products continue to decline, the costs of essentials like housing and medical insurance are steadily rising.

The Federal Reserve, however, will never admit to this duality, as their agenda requires a continuous increase in the money supply. They will use whatever means necessary to downplay inflation, painting it as a non-issue. But there’s a crucial distinction to be made between inflation and hyperinflation. The notion that hyperinflation is imminent is simply unfounded and misleading.

Conclusion: Navigating Economic Uncertainty

Inflation and deflation are complex, intertwined forces influenced by technological advances, market psychology, and global economic shifts. While experts often predict dire outcomes, historical data supports a more balanced view. Investors can navigate these challenges by embracing rational investment strategies, understanding economic trends, and leveraging tools like technical analysis.

As we move forward, it’s crucial to remember that economic realities often defy simplistic narratives. The coexistence of inflationary and deflationary pressures in different sectors of the economy underscores the need for nuanced analysis and adaptable investment strategies.

In this era of rapid technological change and global economic interconnectedness, investors would do well to remain sceptical of alarmist predictions and focus on long-term trends and fundamentals. By doing so, they can turn the fear that often grips markets into a powerful tool for informed decision-making and potential profit.