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The financial market consensus on inflation is pretty obvious: For 2020 and 2021, the U.S. economy will see modest inflation, maybe 1.5% to 1.75%. That would be significantly below the Federal Reserve’s inflation goal of 2% or so. And that gap would keep the Fed focused on stimulating the economy to push inflation higher (and not so incidentally to right the current coronavirus recession, which could show the U.S. economy contracting at a 40% annual rate in the April through June quarter.)

If you were graphing the beliefs of market participants on inflation expectations, you’d get something like a standard bell curve with a big bump around the middle of the graph that corresponded to that inflation consensus. Let’s remember that this consensus and that swell in the bell curve is very important to the current market rally since it underlies the market’s assumption that the economy will see solid growth for the second half of 2020 and into 2021 but that the Federal Reserve will remain worried enough to keep pouring billions and billions of stimulus into an economy that’s growing at a rate below its theoretical maximum.

But this bell curve would also show discernible tails at either end of the graph. To the left there would be a tail that represented a belief in deflation, an actual drop in prices, during this period. To the right there would be a tail that represented a belief in a spike of inflation, a surge in prices above the Fed’s 2% target, much above that target, in fact.

And if you had been graphing these  inflation expectations over the past month or two, as the coronavirus recession took hold and as the Federal Reserve and the federal government spent more than $6 trillion to stabilize markets and fend off the worst consequences to the “shelter-at-home” orders that shut much of the U.S. economy, you would have noticed that the magnitude of these statistical tails was increasing.

Oddly enough financial markets participants are increasingly worried about the possibility of devastating deflation and destabilizing high inflation. It’s a tribute to the unprecedented situation that we find ourselves in that financial market participants are increasingly worried about extreme events, low probability events, that lie on opposite ends of possible outcomes. We obviously can’t experience both of these outcomes–you can’t have deflation and high inflation at the same time. But an increasing, but still small, percentage of market participants is worried about the possibility of some  sort of extreme outcome in the financial markets.

Let’s start with deflation, ok?

The savage drop in oil prices–at one point recent oil for future delivery was trading at deeply negative prices–is the Patient 0 of deflation fears. Global demand for oil was sagging even before the coronavirus recession struck. With so many economies going into some sort of stay at home lock down global oil demand collapsed by 35 million barrels a day. Producers tried to make cuts to reduce the excess of supply over demand but could agree on only about 15 million barrels a day of reductions (and that’s if you count generously and assume every producer is going to live up to pledges.) That has left the world swimming in oil–especially in April since promised cuts from OPEC and OPEC+ countries didn’t go into effect until May. Oil prices have recovered in early May on production cuts and hopes that economic re-opening in countries around the world will revive demand. U.S. benchmark West Texas Intermediate traded at $25.16 a barrel on May 7. Which is certainly a whole lot better than $0 but is still a long way away from the $50 a barrel that many producers need to attain breakeven. Some forecasts say that oil prices could remain low for the rest of 2020 and into 2021 because demand from industries such as travel in general and airlines in particular will bounce back only slowly.

Which leaves us with possible long-term deflation in the oil industry with prices stuck at low levels. Our experience with deflation in oil and other sectors also suggests that deflation can stick around for  long, long time because whenever prices start to lift toward breakeven, producers  uncap wells and put more barrels on the market. And that drives down prices again.

Those worried about deflation say “If it can happen to oil, why can’t it happen to….” These worries usually begin with other commodity sectors. Lithium, the key element for rechargeable batteries, was facing a short-term (in my opinion) surplus in supply due to the large number of projects set to come in line in 2020 and 2021 even before the coronavirus recession sapped demand for electric cars and smartphones and other battery-heavy sectors. Copper tracks economic activity very closely because demand from such sectors as construction responds very quickly to any slowdown in economic activity.

But deflation worries now extend far beyond commodity sectors to economic activity in general. The worry is that fear of a return of the coronavirus (perhaps in multiple waves with the next wave in the fall) will lead to an extended decline in demand for everything from movies to restaurant meals to air travel. That sagging demand would produce deflation in two ways–with directly lower prices as producers try to stimulate sales and with falling wages. The older economy didn’t respond to falling demand with wage cuts very quickly. Companies were relatively reluctant to cut wage rates. The current economy, however, is much more likely to respond to falling demand with immediate cuts to wages in the form of fewer hours for part-time or gig workers. The negative feedback possibilities are quite damaging as lower demand leads to smaller checks for workers that lead to lower demand from workers who don’t have as much to spend.

One of the reasons that market participants and central banks fear deflation is that Japan is a long-running experiment in deflation–and the results haven’t been pretty. Once deflation expectations have been embedded in an economy–and everybody expects prices to be lower tomorrow than they are today–Japan’s experiment shows that it is extremely hard to dislodge these expectations and that deflationary expectations do produce extended very slow economic growth. The effect of millions of consumers putting off spending because prices will be lower tomorrow can produce, as it has in Japan, decades of slow growth that are not responsive to standard central bank policies such as sending interest rates to 0% and below.

Part of Fed policy, under Powell and his predecessors, has been to avoid having the U.S. economy develop those deflationary expectations. I don’t see any reason to believe the Fed has forgotten that policy. And I think that’s one reason to believe that if the Fed sees the economy moving toward deflation it will exert all its powers to prevent the economy from following that course. That would mean even more stimulus, even more cash dropped into the financial markets and, if the central bank can figure out how, into the real economy. No guarantee that any of that intervention would work–the Bank of Japan and the Japanese government have tried many of those measures (not always consistently, it’s true) and they haven’t been sufficient. But the Fed will try.

Which in a round-about way brings me to the other, opposite, fat-tail fear. It’s obvious where the fear of an inflationary spike comes from: so far, with more spending under discussion in Congress, the “bill” for rescuing the economy from the coronavirus and its associated recession has resulted in a $4 trillion deficit for 2020 and one that’s likely to be as big for 2021. That much deficit spending provides, economic theory says, a profound boost to the economy and to consumer spending–and, perhaps, to prices.

Especially if you add in the effects from leaving interest rates near 0% or lower for a long, long period of time. Very cheap money from a long time tends to push up inflation–all other things being equal, which they aren’t now, of course.

The odds for an inflationary spike seem small to me–and to the vast number of market participants too–as far as I can judge. But the odds aren’t zero. If all the stimulus, and debt, and cheap money from the Fed do indeed get poured on the coals of an economy that are burning more hotly than it now appears, we could get a surge in prices. The most likely time to see that take off would be in the third quarter when, let’s imagine, the economy snaps back more quickly than expected after a brutal second quarter. With that snapback, some of the current coronavirus rescue spending would turn out to be an overshoot and we’d wind up with lots and lots of demand chasing supply that had decreased during the coronavirus recession.

In my own opinion, deflation is a greater possibility than an inflationary spike even through I’m in awe of the amount of debt that the Fed, the Treasury, and Congress have created.

But what’s most of interest to me as an investor, a market participant, is that two essentially opposite low probability events are gaining traction in the financial market at the same time. To me that speaks to the extreme uncertainties in the current market and economic situation. We have ventured into truly unknown territory. This is the fastest drop from the biggest rally that we’ve ever seen. The number of jobs destroyed in so short a period is unprecedented. We really don’t have any convincing models to tell us how this all comes out.

Under the circumstances, entertaining the possibility of total opposite low probability outcomes seems only reasonable. And now all we have to do is figure out how to hedge these low probability events if the odds of one or the other–or both–start to rise. We’ve got time–I would estimate that the trends won’t become clear enough to hedge until the fall, if, we don’t see another big wave of coronavirus infections then (a very big IF, I know) , I believe, but we’re going to need it to figure out a strategy. Especially if it’s deflation that looks likely. We’ve got lots of experience and tools for coping with inflation spikes. That’s not the situation with deflation, unfortunately.