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
Inflation hawks are widely viewed as a modern-day equivalent of The Boy Who Cried Wolf. When the US Federal Reserve (Fed) and other central banks started ‘printing’ money like it was going out of fashion in early 2009 to fight the financial crisis, warnings of impending inflation were everywhere. After all, one of the oldest ideas in economics is the relationship between the quantity of money and prices. However, the repeated cries of threat have all proved unfounded, discrediting each subsequent warning.
In 2010, a group of economists, fund managers, academics and journalists wrote to the Fed, opposing its policy of buying long-term debt to push down long-term interest rates. The letter warned it risked “currency debasement and inflation” and should be “reconsidered and discontinued”. One outspoken investor even went as far as to proclaim he was “100 per cent certain” the US was heading for Zimbabwean levels of hyperinflation.
Those sirens proved to be a false alarm. Despite massive monetary stimulus, inflation has failed to materialise. In the US, for instance, the consumer price index rose by an average of just 1.75 per cent in the decade to the end of 2019. Inflation has been no more evident elsewhere, averaging just two per cent in the UK and 1.34 per cent in the euro zone.1
While it is easy to be wise after the event, perhaps the inflation hawks should have known better. After all, by the start of 2009 the Bank of Japan had been experimenting with quantitative easing for nearly eight years,2 and interest rates had been below one per cent for well over a decade. During that time, prices fell.3
Guess who’s back?
However, with central banks dreaming up ever more extreme monetary stimulus and government debt simultaneously soaring as authorities try to limit the damage from what promises to be the deepest recession since the Great Depression, inflation hawks are back. “Get Ready for the Return of Inflation” warned Tim Congdon, a well-known monetarist and former advisor to the British government, in an opinion piece for The Wall Street Journal.4 “Coronavirus will awaken inflationary forces before the year is out” was the headline of another opinion piece, this time in the Financial Times.5
Financial markets appear sceptical. As Figure 1 shows, US inflation, as implied by the yield differential between government bonds that protect against it and those that do not, is expected to average little more than one per cent over the next decade.
Figure 1: US 10-year breakeven inflation
At first glance, 12 years of real-world experiments with previously unimaginable levels of monetary stimulus (in Japan’s case significantly longer) trumps the theories of celebrated economist Milton Friedman. However, in reality the situation is more complex. To see why money printing on this scale failed to generate inflation, it is necessary first to understand the difference between the ‘monetary base’ and the ‘money supply’.
The monetary base is the total currency circulating, plus the physical currency held in the vaults of commercial banks, plus those same banks’ reserves held by the central bank. It can only be altered by the central bank via the setting of interest rates and other monetary operations – for example, when it buys assets from commercial banks the monetary base rises and vice versa.
The money supply, by contrast, is outside the direct control of the central bank. In the US, M1 consists of the monetary base, less money held in banks’ vaults, plus balances in checking, or current, accounts. M2 adds short-term savings deposits to M1. These measures of the money supply increase each time a bank makes a loan and contract when it receives a principal payment on that loan.
Banks in the US, as in most other countries, are required to hold only a fraction of their deposit liabilities in cash – either in their vaults or in their reserve account at the Fed. As a result, with a fractional reserve rule of say ten per cent, the banking system can add ten dollars to the money supply for every new dollar of reserves added to the banking system by the Fed through its open-market operations. Hence the use of the term ‘high-powered money’ to describe the monetary base.
As Figure 2 shows, between 1990 and 2008, M2 was between eight and ten times the size of the monetary base, while M1 was between one and a half and three times as big. But when the financial crisis struck in September 2008, both of these monetary multipliers collapsed. And they have remained well below pre-crisis levels ever since.
Figure 2: Decline in US money multipliers
Collapse of the money multipliers
So, while measures of the money supply have climbed appreciably, they have risen nowhere near as much as might have been expected given the massive expansion of the monetary base by the Federal Reserve. As at the end of 2019, the US monetary base totalled $3.43 trillion, up 304 per cent from August 2008. Prior to the financial crisis, a quadrupling of the monetary base would have been expected to lead to a six-fold increase in M1. Instead, it has risen less than 180 per cent. As for M2, a whopping 32-fold surge might have been expected. In fact, it has not even doubled, as seen in Figure 3.6
Figure 3: M2 fails to keep pace with base money
There appear to be two main reasons for this collapse in money multipliers. Firstly, following the financial crisis, regulators tightened capital requirements in an effort to shore up banking systems to reduce the risk of another crisis. Changes included new measures of capital and increased minimum requirements, with special emphasis on requirements for the largest and most systemically important banks.
US banks, for instance, had to increase the ratio of liquid assets to less-liquid ones on their balance sheets. The effect was to make it more costly for banks, particularly smaller ones, to originate higher-return loans, including small-business loans.
Quantitative easing has had very little effect on bank credit, or broader money, because there’s been such very heavy regulation of bank lending
As Patrick Minford, professor of applied economics at Cardiff Business School and a former advisor to the UK government, says: “Up to now, quantitative easing has had very little effect on bank credit, or broader money, because there’s been such very heavy regulation of bank lending.”
At the same time, banks’ willingness to accumulate reserves, essentially parking money at central banks, has risen. In the US, for example, prior to the crisis bank reserves earned no interest. That meant banks fully leveraged their reserves by lending as much as they could to maximize profits, with excess bank reserves limited to just a few billion dollars. But in recent years they have held unprecedented levels of reserves, over and above what they are required to, with the central bank, as Figure 4 shows.
Figure 4: Excess reserves of US depository institutions ($ bn)
Since October 2008, the Fed has been paying interest on bank reserves, at rates generally exceeding the yield on Treasury securities. That has given banks a reason to prefer cash reserves over government securities for their liquidity needs. In a July 2009 staff report, the New York Fed said the rise in excess reserves was almost entirely due to Fed policy.7
The collapse in money multipliers helps explains why inflation has not taken off, since it is the money supply and not the monetary base that affects inflation in the real economy. With most of the money injected by central banks clogged up in the financial system and not making it out into the real economy, the result has been asset price inflation instead.
A number of economists, including former US Treasury Secretary Lawrence Summers and Nobel Prize-winner Paul Krugman, have for some time argued inflation was never likely to resurface because developed economies are suffering from ‘secular stagnation’, the effects of which were masked by a credit bubble in the run up to the financial crisis. In their view, a combination of factors, such as a glut of savings, weak investment, globalisation, worsening demographics and rising inequality, have for years exerted downward pressure on growth and inflation.
So, while the amount of money circulating in the real economy has risen, the increase has been insufficient to counteract these deflationary forces. However, other economists, especially disciples of Friedman, argue it would be wrong to assume massive monetary stimulus will not lead to inflation in future just because it failed to do so following the financial crisis, especially since the current circumstances are quite different.
Monetary financing on this scale isn’t having much inflationary effect at the moment because everything’s in disarray
In contrast to the financial crisis, banks are now being encouraged to lend to businesses. “Monetary financing on this scale isn’t having much inflationary effect at the moment because everything’s in disarray. But we should be on the lookout for quite a big rise in broad money. The time to worry about it is when we get into recovery,” says Minford.
Charles Goodhart, former chief economist at the Bank of England, agrees: “What will then happen as the lockdown gets lifted and recovery ensues, following a period of massive fiscal and monetary expansion? The answer, as in the aftermath of wars, will be a surge in inflation.”8 Like Minford, he sees less reason why monetary stimulus will remain jammed in banking systems, while also arguing there is scope for economies to rebound far quicker than in 2009.
For now, it would probably be fair to say views such as these remain in the minority. After all, there is little sign of an early end to the monetary merry-go-round. Since the end of last year, the Fed has expanded the US monetary base by $1.71 trillion, with the majority being parked back at the central bank in the form of excess reserves.
In a recent article, the International Monetary Fund’s former chief economist Olivier Blanchard said it is hard to see a strong wage push on the horizon given the increase in unemployment. While it would be wrong to dismiss the threat of inflation entirely, with oil prices having also collapsed and precautionary saving likely to remain elevated for some time to come, the odds were heavily stacked against it. “The challenge for monetary and fiscal policies is likely to be to sustain demand and avoid deflation rather than the reverse,” he wrote.9
The end of globalisation?
Peter Fitzgerald, multi-asset and macro chief investment officer at Aviva Investors, sides with him. “We’ve got a massive demand shock taking place and it’s hard to see where inflation is coming from in the short term.”
However, he believes inflation poses a growing threat over the long term. China has had a big deflationary impact on the world since it joined the World Trade Organisation in 2001, but Fitzgerald sees a real risk of this being at least partially reversed. “Given the ongoing trade war with the US, and after the pandemic highlighted to other governments the danger of not being able to get hold of essential goods, de-globalisation could become a real inflationary force,” Fitzgerald warns.
Sunil Krishnan, Aviva Investors’ head of multi-asset funds, agrees. He says there is a trade-off between corporate efficiency and resilience, with the current crisis demonstrating the danger of companies focusing almost exclusively on the former in recent years.
“Rather than having a single supply chain that spans the globe, in future companies might keep two supply relationships going. Instead of just-in-time inventory management, we may see more re-shoring of factories as firms realise they can’t afford to have inventory stuck on the other side of the world. This has obvious cost implications,” he says.
Inflation could pose a bigger risk looking further ahead, meaning the US yield curve currently looks too flat
Although inflation is unlikely to return in the near future, James McAlevey, head of rates at Aviva Investors, believes it could pose a bigger risk looking further ahead, meaning the US yield curve currently looks too flat.
“Whereas much of the world adopted austerity measures following the financial crisis, today the opposite is happening. That means the outcome could be quite different, especially if the Fed decides it is prepared to tolerate inflation overshoots,” he says.
All three believe spiralling government deficits could lead to appreciably higher inflation if central banks were to fund governments directly – a policy sometimes known as monetary financing – as a growing band of economists are advocating.
Indeed, in a less well-known section of his speech of 1970, entitled The Counter-Revolution in Monetary Theory, Friedman warned higher government spending “will clearly be inflationary if it is financed by creating money, that is, by printing currency or creating bank deposits”.
Heeding this warning, central banks are adamant they intend to sell the government debt they have acquired as a result of quantitative easing back into the market as and when the time is right. They say monetary financing will lead to runaway inflation, even if the recent experience of Japan suggests otherwise.
However, some economists say monetary financing is precisely what central banks should now be doing. Adair Turner, former chairman of the UK’s Financial Services Authority, and Mervyn King, former head of the Bank of England, are among them.
“I think it is pretty axiomatically obvious that the impact on inflation of monetary financing all depends on how much you do,” argues Lord Turner, pointing out it was the same Milton Friedman who laid out the rationale for monetary financing in 1948 and went on to coin the term ‘helicopter money’ in a subsequent article of 1969.
Nonetheless, he concedes that if that decision were taken out of central bankers’ hands by politicians, there would be a real risk of much higher inflation. For that to happen, a central plank of economic policymaking for the past four decades would have to be abandoned.
In the 1980s, governments around the world began handing central banks greater control over monetary policy as they searched for a cure for rampant inflation that had plagued their economies the previous decade. Politicians’ failure to maintain monetary discipline was considered a major cause of inflation getting out of control.
Central banks have failed to reignite economic activity and, in the eyes of many, have fuelled inequality
But just as high inflation in the 1970s led to central banks being handed independence, could a prolonged period of deflation result in it being taken away? It is no coincidence that recent years have seen growing calls for this. After all, central banks have failed to reignite economic activity and, in the eyes of many, have fuelled inequality. Around the world they have been under attack from politicians, most notably US President Donald Trump, who has been a relentless critic of the Fed.
Fitzgerald says that should economic growth continue to disappoint in the coming years, which is a distinct possibility, populist politicians may find the urge to wrest back control of monetary policy impossible to resist. “There are ultimately only three ways to lower debt. Either you pay it back, you default on it or forgive it, or you inflate it away. Many governments might be tempted to go for the latter option,” Fitzgerald says.
He believes investors should continue to look for ways to protect their portfolios against the threat of rising inflation, for example by investing in gold or taking positions in longer-dated inflation swaps, even if – for now – warnings of impending inflation look likely to another case of The Boy Who Cried Wolf.