By Axel A. Weber
Government deficits in 2020 were thus indirectly financed by the issuance of new money. But this will work only if enough savers and investors are willing to hold money and government bonds at zero or negative interest rates. If doubts about the soundness of these investments were to prompt savers and investors to switch to other assets, affected countries’ currencies would weaken, leading to higher consumer prices.
Previous episodes of excessive government debt almost always ended with high inflation. Inflation caused by a loss of confidence can emerge quickly and in some cases at a time of underemployment, without a preceding wage-price spiral.
Although expansionary monetary policy after the 2008 global financial crisis did not lead to increasing inflation, this is no guarantee that price growth will remain low this time. After 2008, newly created liquidity flowed mainly into financial markets. But central banks’ current balance-sheet expansion is triggering large money flows into the real economy, through record fiscal deficits and rapid credit growth in many countries. Moreover, the monetary-policy response to the pandemic was much faster and more substantial than in the last crisis.
Demographic shifts, increasing protectionism, and the Federal Reserve’s de facto increase last year of its 2% inflation target are among other factors that could lead to higher inflation in the longer term. Although these structural factors are unlikely to trigger a surge in price growth in the short term, they could still facilitate it.
A sharp rise in inflation could have devastating consequences. To contain it, central banks would have to raise interest rates, which would create financing problems for highly indebted governments, firms, and households. Historically, central banks have mostly been unable to resist government pressure for sustained budget financing. This has often resulted in very high rates of inflation, accompanied by large losses in the real value of most asset classes and political and social upheaval.
In recent months, commodity prices, international transport costs, stocks, and bitcoin have all risen sharply, and the U.S. dollar /zigman2/quotes/210673925/realtime XX:BUXX -0.39% has depreciated significantly. These could be harbingers of rising consumer prices in the dollar area. With inflation rates highly correlated internationally, higher inflation in the dollar area would accelerate price growth world-wide.
Watching the markets: Dow retreats as rising bond yields and inflation fears spook stock market
Too many are underestimating the risk of a rise in inflation, and sanguine model-based forecasts do nothing to alleviate my fears.
Monetary and fiscal policy makers, as well as savers and investors, should not allow themselves to be caught out. In 2014, former Fed Chair Alan Greenspan predicted that inflation would eventually have to rise, calling the Fed’s balance sheet “a pile of tinder.” The pandemic could well be the lightning strike that ignites it.
This commentary was published with permission of Project Syndicate—Will Inflation Make a Comeback?
Axel A. Weber, a former president of the Deutsche Bundesbank and former member of the Governing Council of the European Central Bank, is chairman of the Board of Directors of UBS Group AG.