• Risk
  • Economic Research

Inflation hawks, crying wolf

Part 3 of our series exploring the potential source of the next global crisis

Twelve years on from the financial crisis, inflation hawks are back. They were proved wrong then, but could this time be different? In part three of our mini-series on the source of the next crisis, we explore the extent to which inflation poses a risk to the global economy and financial stability.

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
US 10-year breakeven inflation
Source: Federal Reserve Bank of St. Louis

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
Decline in US money multipliers
Source: Federal Reserve Bank of St. Louis

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
M2 fails to keep pace with base money
Source: Federal Reserve Bank of St. Louis

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)
Excess reserves of US depository institutions ($ bn)
Source: Federal Reserve Bank of St. Louis

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.

Secular stagnation

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.

Political interference

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.


  1. Source for all figures: Federal Reserve Bank of St. Louis
  2. Mark Spiegel, ‘Quantitative Easing by the Bank of Japan’, Federal Reserve Bank of San Francisco, November 2, 2001
  3. Source: Federal Reserve Bank of St. Louis
  4. Tim Congdon, ‘Get Ready for the Return of Inflation’, Wall Street Journal, April 23, 2020
  5. Karen Ward, ‘Coronavirus will awaken inflationary forces before year is out’, Financial Times, April 16, 2020
  6. Source: Federal Reserve Bank of St. Louis
  7. Todd Keister and James McAndrews, ‘Why Are Banks Holding So Many Excess Reserves?’, Federal Reserve Bank of New York Staff Reports, no. 380, July 2009
  8. Charles Goodhart and Manoj Pradhan, ‘Future imperfect after coronavirus’, VoxEU.org, March 27, 2020
  9. Olivier Blanchard, ‘High inflation is unlikely but not impossible in advanced economies’, Peterson Institute For International Economics, April 24, 2020

Want more content like this?

Sign up to receive our AIQ thought leadership content.

Please enable javascript in your browser in order to see this content.

I acknowledge that I qualify as a professional client or institutional/qualified investor. By submitting these details, I confirm that I would like to receive thought leadership email updates from Aviva Investors, in addition to any other email subscription I may have with Aviva Investors. You can unsubscribe or tailor your email preferences at any time.

For more information, please visit our privacy notice.

Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.