If prices eventually start rising, debt-laden governments may be tempted to embrace them. One of the questions we get asked most frequently is whether the pandemic will usher in a period of higher inflation.
There are several angles to this. One is whether supply restrictions caused by social distancing measures will push up prices. Another is whether the huge amounts of policy stimulus that have been deployed by governments and central banks will ultimately prove to be inflationary. And yet another is whether governments will come to view inflation as the least painful way of tackling the higher debt burdens they have incurred because of the crisis. What should we make of this?
A period of significantly higher inflation is unlikely in the next couple of years. Supply restrictions may lead to a one-off increase in prices in some sectors affected by social distancing measures. But it is important to distinguish between a step-change in prices and continued increases. Inflation is more than just a one-off upward shift in the prices of some items – it is a continual process in which prices across many goods and services increase year after year after year. Headline CPI rates will pick up in 2021 as the large drop in energy prices since the start of this year and, in some countries, cuts to VAT drop out of annual comparisons. But inflation will remain at or below target in most places. This is not the inflationary spike that many fear.
The bigger question surrounds the outlook for inflation beyond the next year or so
Monetarists argue that the huge expansion in the money supply that has resulted from central bank asset purchases will inevitably result in a large and sustained acceleration in inflation. The reality is more complicated. The key issue is whether the money created by central banks works its way into the real economy, and whether it then boosts spending (and aggregate demand) above and beyond the economy’s ability to produce goods and services.
The asset purchases (or QE) that were undertaken by central banks in the wake of the global financial crisis came during a period in which governments were tightening fiscal policy and large parts of the private sector were repairing balance sheets. The money created by central banks therefore got stuck in the financial system. This time, asset purchases have come alongside a period of fiscal expansion – meaning the money is ending up in the hands of households and businesses.
Even so, the links between money growth, demand and inflation are not mechanistic. As things stand, the uncertainty generated by the pandemic means that households and businesses are maintaining higher precautionary cash balances. And even if they do begin to spend these, the significant amount of spare capacity in most economies will prevent inflation from rising.
What’s more, if and when inflation does start to rise, this can be choked off by policy tightening. Central banks can reverse the expansion in the money supply or raise interest rates and reserve requirements. Fiscal policy can be tightened.
The key issue, then, is whether policy is kept too loose for too long. That could happen by accident – central banks and/or governments try to stop inflation from accelerating but act too late. Or it could happen by design.
This raises the question, why would governments want higher inflation?
Inflation imposes significant costs, especially when allowed to run at very high rates. It destroys price signals and, in doing so, leads to a less efficient allocation of resources. Furthermore, even a moderately higher rate of inflation will create losers. These include savers, debt holders and anyone that relies on a fixed income that is not uprated with inflation (for example, some pensioners).
But a higher rate of inflation may also hold some attractions to governments, particularly in a world of higher public debt burdens. If policymakers can keep nominal borrowing costs anchored, either by persuading bond markets that a burst of inflation is temporary or through financial repression, then the real value of debt will slowly fall. And together with continued economic growth, this will over time start to bring down the government’s debt burden.
It is therefore not impossible to believe that governments may eventually come to view a period of moderately higher inflation as the least painful way of dealing with the fiscal costs incurred by the pandemic. If so, the question then becomes whether governments and central banks can generate a moderately higher rate of inflation (as they did in the 1950s and 1960s) without it then spiralling out of control (as happened in the 1970s).
The upshot of all of this is that we should look through any rebound in inflation over the next year and watch instead for any signs of a broader institutional shift towards tolerating higher rates of inflation. But regime shifts tend to move slowly at first. In time, it could prove to be the thin end of a very long wedge.