There is great uncertainty about the future path of inflation, once the recovery occurs. Before discussing the main alternative viewpoints, it may be helpful to remind oneself that the last 70 years have been extraordinary in comparison to previous centuries.
The path of the recovery from the
pandemic will depend on the availability of vaccines and other potential
cures, which remains unknown. But most economists are agreed that we
will eventually return to reasonably full employment, though output
growth may remain low.
However, there is great uncertainty
about the future path of inflation, once the recovery occurs. Before
discussing the main alternative viewpoints, it may be helpful to remind
oneself that the last 70 years have been extraordinary in comparison to
previous centuries.
Understanding the past
Prior to World War II, inflation and
interest rates remained relatively low and constant, except during war
time, and periods of bad, or disturbed, governance. Inflation was
relatively variable on a year-to-year basis, because food was by far the
largest component of most people’s expenditures, and food prices
depended on the variable success of the harvest. Also, at least until
1815, the history of the Western World was punctuated by frequent, but
relatively short-lived, warfare. But once peace returned, e.g. after the
Napoleonic wars were over in 1815, there was a long period of stable
prices. The moneys of the world’s economies were on a metallic standard,
mostly gold after 1873; and some combinations of silver and gold before
then. There were some minor trends in inflation, or deflation,
depending on the relative growth rates of output on the one hand, and of
gold/silver production on the other. The disruption of WWI led to
inflation, but with the world attempting to return to the Gold Standard
thereafter, there was a period of severe deflation in the inter-war
period.
But after WWII, there was first a
massive trend increase in inflation, culminating at the end of the
1970s, followed by some 40 years of falling inflation, from 1980 through
to the present.
This is perhaps most dramatically shown in the diagram of long-term interest rates in the United Kingdom, below.
Figure 1. Consol (Long-term bond) yields in the United Kingdom
Why did these two trends occur?
The attempt to return to the Gold
Standard in the interwar years had been a disaster, and so, after WWII,
countries moved onto a managed exchange rate system, initially the
pegged, but adjustable, Bretton Woods system, under the management of
the IMF. But by then the Keynesian view that the economy should be
primarily managed to maintain full employment had become dominant.
Moreover, the politicians of that generation had grown up during the
Great Depression of the 1930s and were keen to maintain unemployment as
low as reasonably possible. So, they sought to run the economy at a
higher rate of employment than was, in practice, consistent with price
stability. In many countries the hope then was that inflation could be
contained by direct controls on prices and wages. This turned out to be
impossible. Meanwhile, monetary policy accommodated the growing
inflationary pressures. As a result, inflation steadily rose. Eventually
everybody in the economy came to expect higher inflation and,
therefore, put in claims for wages and price increases that would
maintain their real value in the more inflationary context that was
expected.
That, in turn, led to ever-faster
inflation, which culminated in the horrible years of the 1970s, which
were characterised by stagflation, i.e. every-increasing inflation and
policy restraint that was sufficient to reduce output growth, but
insufficient to check the inflationary spiral. It was made much worse by
the spikes in oil prices in 1973/74 and 1979.
This inflationary spiral was finally
broken at the beginning of the 1980s by Paul Volcker, Chairman of the
Federal Reserve Board, with the support of Reagan in the US and Thatcher
in the UK. They temporarily abandoned the overriding pursuit of full
employment and allowed Volcker to tighten monetary policy sufficiently
to break the inflationary spiral. But this led to short-term interest
rates in the US temporarily of over 20%, a severe world-wide recession
and the most dangerous financial crisis in the world prior to that of
2008-2010. One of the conclusions of the time was that the politicians,
in pursuit of reelection, would always be too expansionary, despite
claiming that they wanted to achieve low and stable inflation. This was
dubbed ‘time-inconsistency’. To counter this, towards the end of the
1980s and the beginning of the 1990s, Central Banks were given
independence to set monetary policy, in practice short-term interest
rates, to achieve price stability, independent of government control.
After CBI was introduced in the early 1990s, the world then saw the best
17 years of economic development ever; this was known as the NICE years
(Non-Inflationary and Continuous Expansion). Inflation expectations
came back into line with the inflation target, generally about 2%, and
as a result, nominal interest rates returned to a roughly normal level
of about 3% to 4%.
But the continuous expansion and
declining interest rates led to asset price bubbles, (Minsky),
especially in housing, and the authorities failed to note how fragile
the financial system had become. A downturn in housing prices then led
to the Great Financial Crisis (GFC), and this led to even more
expansionary monetary policy, in order to offset the recession that then
occurred. Underlying the general deflationary pressures was the effect
of globalization in shifting production to cheaper parts of the world,
especially China and the other Asian countries.
So where are we now?
Low for longer?
The most widely accepted view, and that
with most influence on current markets, as evidenced, for example, by
longer term and forward interest rates, is that inflationary pressures
will remain very subdued, and hence monetary policy strongly
expansionary, for at least the next five years, or so. The pandemic has
led to sharp increases in unemployment and/or underemployment, and, even
should a vaccine be found, the dislocations occasioned by the crisis
and lockdown will probably cause major shifts in the pattern of
employment, making it harder to reabsorb those who have currently lost
their jobs. A virtual economy may well be cheaper and less labour
intensive than the old flesh and blood economy. Uncertainties are likely
to remain elevated, raising desired savings ratios, while depressing
investment. It may be years before many of us regain the confidence to
travel; anyhow why do so when you can visit friends and far-off places
more cheaply and safely though zooming over the internet? As we shop
online rather than in high-street stores, the valuations of previously
scarce urban land may tumble. We will watch theatre plays and operas on
our computers, not in situ. For all such reasons the mainstream view is
that inflation will remain low, probably below target, for as long as
the eye can see.
Inflation is a Monetary Phenomenon?
“Inflation is always and everywhere a
monetary phenomenon in the sense that it is and can be produced only by a
more rapid increase in the quantity of money than in output.” Thus,
wrote Milton Friedman in 1970 (The Counter-Revolution in Monetary Theory).
And for much of the rest of the last century that doctrine was treated
as almost self-evident, and taught in most macroeconomic classes at our
universities.
In the first two quarters of 2020, when
the Coronavirus pandemic struck, monetary growth has surged, almost
everywhere, under the combined influence of a precautionary demand for
liquidity in the private sector, a ‘dash for cash’, a massively
increased deficit in the public sector, and the aim of Central Banks to
support the economy via extremely expansionary policies. In the USA
broad money growth has surged to its fastest ever recorded growth rate
of 32% year on year. To a monetarist that means that a sharp rise in
inflation in future years is now almost inevitable.
Qualifications
We are, of course, currently in a
context where the velocity of broad money is dropping just about as fast
as its overall supply is being expanded. This arises from a combination
of massive involuntary saving (people cannot go on holiday, attend
theatres, buy new clothes, etc., etc.), equivalent falls in the incomes
of those supplying such services, (offset by various forms of fiscal
expansion, such as paid furloughs), and precautionary savings. Yes,
indeed, but that will not last. Sometime in the foreseeable future
shops, hotels, even theatres, will reopen, and the related workers will
be rehired. At this point, velocity could revert back towards normality.
And what then?
The second qualification is that Central
Banks could then try to reverse the current monetary expansion, for
example by allowing some of their current bloated holdings of government
debt to run off. But that would put pressure on debt markets, at a time
when debt ratios everywhere will be historically high and still rising
fast. Even if official short-term rates were held down to present
extraordinarily low levels, longer-term rates would, probably, be forced
upwards. Central Banks could come under political pressure not to
reverse course too abruptly.
There are other grounds for expecting
higher inflation. The reversal of globalisation, and greater national
protection, will disrupt supply chains, shift production to more
expensive sites and strengthen labour (Trades Union) bargaining power in
each country. Worsening debt burdens, in a state of high uncertainty,
could lead business to seek higher profit margins, rather than
competitive expansion. Nevertheless, the key determinant, on this view,
of the likely resurgence in inflation is the monetary (and fiscal)
policies adopted to counter the pandemic.
So What Will Happen?
At this point in time, there are,
therefore, two strongly held, but contrasting, views about the likely
future path of inflation, following a proper recovery from the pandemic.
The mainstream position is that the continuing dislocations in, and
weakness of, the real economy will preclude any recovery in inflationary
pressures for the foreseeable future, say the next three to five years,
‘lower for longer’.
The contrary view is that, once the
recovery has got underway, the expansionary monetary, and fiscal,
measures already adopted will generate a resurgence in inflation, partly
because an early reversal of such policies would just then be too
painful for our economies to bear. In addition longer term trends, away
from globalisation and with a slower growing workforce, will underpin
inflation.
Apart from the important practical
implications of finding out which of these positions is more nearly
correct, it will affect macroeconomic theory and teaching, perhaps
forever.
We shall see.
SUERF
© SUERF