NEW YORK ( Project Syndicate )—There is a growing debate about whether the inflation that will arise over the next few months will be temporary, reflecting the sharp bounceback from the COVID-19 recession, or persistent, reflecting both demand-pull and cost-push factors.
Several arguments point to a persistent secular increase in inflation, which has remained below most central banks’ annual 2% target for over a decade.
Arguments for inflation
The first holds that the United States has enacted excessive fiscal stimulus for an economy that already appears to be recovering faster than expected. The additional $1.9 trillion of spending approved in March came on top of a $3 trillion package last spring and a $900 billion stimulus in December, and a $2 trillion infrastructure bill will soon follow.
The U.S. response to the crisis is thus an order of magnitude larger than its response to the 2008 global financial crisis.
The counterargument is that this stimulus will not trigger lasting inflation, because households will save a large fraction of it to pay down debts. Moreover, investments in infrastructure will increase not just demand but also supply, by expanding the stock of productivity-enhancing public capital. But, of course, even accounting for these dynamics, the bulge of private savings brought by the stimulus implies that there will be some inflationary release of pent-up demand.
A second, related argument is that the Federal Reserve and other major central banks are being excessively accommodative with policies that combine monetary and credit easing. The liquidity provided by central banks has already led to asset inflation in the short run, and will drive inflationary credit growth and real spending as economic reopening and recovery accelerate.
Some will argue that when the time comes, central banks can simply mop up the excess liquidity by drawing down their balance sheets and raising policy rates from zero or negative levels. But this claim has become increasingly hard to swallow.
Centrals banks have been monetizing large fiscal deficits in what amounts to “helicopter money” or an application of Modern Monetary Theory.
At a time when public and private debt is growing from an already high baseline ( 425% of gross domestic product in advanced economies and 356% globally ), only a combination of low short- and long-term interest rates can keep debt burdens sustainable. Monetary-policy normalization at this point would crash bond and credit markets, and then stock markets /zigman2/quotes/210599024/realtime GDOW +1.13% /zigman2/quotes/210598058/realtime DWCF +0.84% /zigman2/quotes/210599714/realtime SPX +0.74% , inciting a recession. Central banks have effectively lost their independence.
Here, the counterargument is that when economies reach full capacity and full employment, central banks will do whatever it takes to maintain their credibility and independence. The alternative would be a de-anchoring of inflation expectations that would destroy their reputations and allow for runaway price growth.
A third claim is that the monetization of fiscal deficits will not be inflationary; rather, it will merely prevent deflation. However, this assumes that the shock hitting the global economy resembles the one in 2008, when the collapse of an asset bubble created a credit crunch and thus an aggregate demand shock.
The problem today is that we are recovering from a negative aggregate supply shock. As such, overly loose monetary and fiscal policies could indeed lead to inflation or, worse, stagflation (high inflation alongside a recession). After all, the stagflation of the 1970s came after two negative oil-supply shocks following the 1973 Yom Kippur War and the 1979 Iranian Revolution.
In today’s context, we will need to worry about a number of potential negative supply shocks, both as threats to potential growth and as possible factors driving up production costs. These include trade hurdles such as de-globalization and rising protectionism; post-pandemic supply bottlenecks; the deepening Sino-American cold war; and the ensuing balkanization of global supply chains, and reshoring of foreign direct investment from low-cost China to higher-cost locations.
Equally worrying is the demographic structure in both advanced and emerging economies. Just when elderly cohorts are boosting consumption by spending down their savings, new restrictions on migration will be putting upward pressure on labor costs.