The world economy

After the pandemic, will inflation return?

Low inflation underpins today’s economic policy. It is not guaranteed to last

Dec 12th 2020

ECONOMISTS LOVE to disagree, but almost all of them will tell you that inflation is dead. The
premise of low inflation is baked into economic policies and financial markets. It is why
central banks can cut interest rates to around zero and buy up mountains of government
bonds. It explains how governments have been able to go on an epic spending and borrowing
binge in order to save the economy from the ravages of the pandemic—and why rich-world
public debt of 125% of GDP barely raises an eyebrow. The search for yield has propelled the
S&P 500 index of shares to new highs even as the number of Americans in hospital with
covid-19 has surpassed 100,000. The only way to justify such a blistering-hot stockmarket is
if you expect a strong but inflationless economic rebound in 2021 and beyond.

Yet as we explain this week (see article), an increasingly vocal band of dissenters thinks that
the world could emerge from the pandemic into an era of higher inflation. Their arguments
are hardly overwhelming, but neither are they empty. Even a small probability of having to
deal with a surge in inflation is worrying, because the stock of debt is so large and central-
bank balance-sheets are swollen. Rather than ignore the risk, governments should take action
now to insure themselves against it.

In the decades since Margaret Thatcher warned of a vicious cycle of prices and wages that
threatened to “destroy” society, the rich world has come to take low inflation for granted.
Before the pandemic even an ultra-tight jobs market could not jolt prices upwards, and now
armies of people are unemployed. Many economists think the West, and especially the euro
zone, is heading the way of Japan, which fell into deflation in the 1990s and has since
struggled to lift price rises far above zero.

Predicting the end of this trend is a kind of apostasy. After the financial crisis some hawks
warned that bond buying by central banks (known as quantitative easing, or QE) would
reignite inflation. They ended up looking silly.

Today the inflationistas’ arguments are stronger. One risk is of a temporary burst of inflation
next year. In contrast to the period after the financial crisis, broad measures of the rich-world
money supply have shot up in 2020, because banks have been lending freely. Stuck at home,
people have been unable to spend all their money and their bank-balances have swelled. But
once they are vaccinated and liberated from the tyranny of Zoom, exuberant consumers may
go on a spending spree that outpaces the ability of firms to restore and expand their capacity,
causing prices to rise. The global economy already shows signs of suffering from bottlenecks.
The price of copper, for example, is 25% higher than at the start of 2020.
The world should be able to manage such a temporary burst of inflation. But the second
inflationista argument is that more persistent price pressures will also emerge, as structural
disinflationary forces go into reverse. In the West and in Asia many societies are ageing,
creating shortages of workers. For years globalisation lowered inflation by creating a more
efficient market for goods and labour. Now globalisation is in retreat.

Their third argument is that politicians and officials are complacent. The Federal Reserve
says it wants inflation to overshoot its 2% target to make up for lost ground; the European
Central Bank, which announced more stimulus on December 10th, may yet follow suit.
Weighed down by the need to pay for an ageing population and health care, politicians will
increasingly favour big budget deficits.

Might these arguments prove correct? A temporary rebound in inflation next year is perfectly
possible. At first it would be welcome—a sign economies were recovering from the
pandemic. It would inflate away a modest amount of debt. Policymakers might even breathe a
sigh of relief, especially in Japan and the euro zone, where prices are falling (though rapid
changes in the pattern of consumer spending may have muddied the statistics).

The odds of a more sustained period of inflation remain low. But if central banks had to raise
interest rates to stop price rises getting out of hand, the consequences would be serious.
Markets would tumble and indebted firms would falter. More important, the full cost of the
state’s vastly expanded balance-sheet—both governments’ debt and the central banks’
liabilities—would become alarmingly apparent. To understand why requires peering, for a
moment, into how they are organised.

For all the talk about “locking in” today’s low long-term interest rates, governments’ dirty
secret is that they have been doing the opposite, issuing short-term debt in a bet that short-
term interest rates will remain low. The average maturity of American Treasuries, for
example, has fallen from 70 months to 63. Central banks have been making a similar wager.
Because the reserves they create to buy bonds carry a floating interest rate, they are
comparable to short-term borrowing. In November Britain’s fiscal watchdog warned that a
combination of new issuance and QE had left the state’s debt-service costs twice as sensitive
to short-term rates as they were at the start of the year, and nearly three times as much as in
2012.

So while the probability of an inflation scare may have risen only slightly, its consequences
would be worse. Countries need to insure themselves against this tail risk by reorganising
their liabilities. Governments should fund fiscal stimulus by issuing long-term debt. Most
central banks should start an orderly reversal of QE and instead loosen monetary policy by
taking short-term interest rates negative. Finance ministries should incorporate risks taken by
the central bank into their budgeting (and the euro zone should find a better tool than QE for
mutualising the debts of its member states). Shortening the maturity of the state’s balance-
sheet—as in 2020—must only ever be a last resort, and should not become the main tool of
economic policy.

In praise of mothballs
The chances are the inflationistas are wrong. Even the arch-monetarist Milton Friedman, who
inspired Thatcher, admitted late in his life that the short-term link between the money supply
and inflation had broken down. But the covid-19 pandemic has shown the value of preparing
for rare but devastating events. The return of inflation should be no exception. ■

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