Expert Commentary

Supply Side "Shock" - Deflation and Stagflation Ahead?

The nascent economic collapse could lead to both debt reduction and higher consumer prices.

Subscribers to Elliott Wave International's publications will not have been surprised by the collapse in stock markets during the past few weeks. However, to most people it has come as a big shock which, of course, is being blamed on the impact the Coronavirus is having on economic activity. The penny is dropping that central banks are impotent in being able to turn things round. No amount of Fed rate cuts will bring back lost production or cancelled flights.

What is happening is known as a "supply side shock" in economics. The supply of goods and services is falling, even though demand (for the latest iPhone for instance) might still be there. The policy tools available to central banks are aimed at altering the demand side of the economic equation and so all they can do is sit back and watch supply side impacts play out.

The most famous "supply side shock" in the modern era was the 1973-74 "Oil Shock." Arab petroleum exporting countries proclaimed an oil embargo targeted at nations perceived as supporting Israel during the Yom Kippur War. The price of oil sky-rocketed and economic growth slowed. That was when the word "stagflation" (a portmanteau of stagnation and inflation) appeared in the economic lexicon to describe a situation whereby the prices of many goods and services were accelerating higher coincident with weak or negative economic growth.

The current situation could see something similar. Curtailed supply of goods and services might mean higher prices. At the same time, economic growth is slowing - Germany is almost certain now to go into recession. The difference between 2020 and the 1970s, though, is that the level of debt is so much greater. Collapsing asset prices and economic growth will inevitably lead to debt-deflation as confidence disappears.

Thus, get ready for a period of deflation (of the monetary variety) and higher consumer prices. Do not be surprised if "stagflation" is all over the airwaves in coming months.

A Supply-Side "Shock"