After coronavirus: deflation or inflation?

Most economists are reasonably confident that once the pandemic has subsided, employment will eventually recover to its previous normal levels. But there are two markedly different schools of thought on the future of inflation: further deflationary pressures or a return to systemic inflation.

Inflation used to be a consequence of wars and/or bad governance. So, during the largely peaceful century from 1815 to 1914, the price level, and consequently interest rates, remained largely stable. After inflation in the First World War, the interwar period, 1919-39, saw deflation. But after the Second World War, there was a shocking trend rise in inflation and in interest rates, peaking at the end of the 1970s and early 1980s. This has been ascribed to trying to run the economy at too high a level of employment, thereby shifting power to trades unions, combined with accommodating monetary policies.

After an epic struggle in the early 1980s, led by Paul Volcker in the United States, inflation was conquered, ushering in three decades of low, even below target, inflation and a trend decline in interest rates to exceptionally low levels. This has, in turn, been ascribed to better monetary policies, and, latterly, with inflation below target despite very expansionary monetary policies, to various structural trends, although the identification and weight placed on each of these has remained uncertain.

The effects of these three regimes are shown, rather dramatically in this chart of the time paths of Consol rates (yields on long-term bonds) in the UK.

Figure 1: Long-term bond yields in the United Kingdom

Graph showing long-term bond yields from 1760 to 2020

Source: Bank of England.
Note: The data shown is for Consols to the end of 2016 and for 20-year yields from 2017 onwards.

Lower for longer?

The most widely accepted view, and the one with most influence on current financial 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. 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 far 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 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 United States, broad money growth has surged to its fastest ever recorded growth rate of 25% year-on-year. To a monetarist, that means that a sharp rise in inflation in future years is now almost inevitable.

But that depends on two qualifying considerations. The first is that the velocity of money usage, which has currently declined dramatically, will start to revert to its normal level. The velocity of (any of) the monetary aggregates can change quite dramatically, even over short periods.

An obvious example of the latter is the total collapse of the velocity of the monetary base (M0) in the aftermath of its huge expansion via QE (‘quantitative easing’) following the 2008/09 global financial crisis. This was in some large part because a combination of interest on excess reserves, regulation and a desire for liquidity moved commercial banks into a liquidity trap, where they were prepared to mop up excess reserves almost without limit, thereby disrupting the transmission mechanism to the broader monetary aggregates and the real economy beyond.

We are 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.), 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 and 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 were historically high and still rising fast. Even if official short-term rates were held down to the 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.

The ratio of dependents to workers is worsening almost everywhere; so tax rates will be rising. 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, 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 then be just 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.

Where can I find out more?

Inflation after the pandemic: theory and practice: Writing at VoxEU, Charles Goodhart says that ignoring the potential inflationary dangers is the equivalent to an ostrich putting its head in the sand.

Is there deflation or inflation in our future? Writing at VoxEU, Olivier Blanchard concludes that the challenge for monetary and fiscal policy is likely to be to sustain demand and avoid deflation rather than the reverse.

Will Covid-19 be followed by inflation? An inter-generational transfer perspective: Writing at VoxEU, Lubos Pastor suggests that the easiest way for central banks to deal with Covid-spawned debt may be to tolerate above-average inflation.