When oil prices sank to zero last May, few investors thought of inflation. But those who study data on monetary conditions knew that the unprecedented build-up in liquidity would see the economy boom and prices rise as soon as vaccines put an end to the pandemic. The monetary data are striking. M2, the measure of broad-based money supply, jumped by a sharp 24% between March and November last year.
Shockingly, the money supply surge in 2020 exceeded any in the one and a half centuries for which we have data.
Monetary expansion has also been robust in much of the rest of the world but nowhere nearly as pronounced as in the US. The new Biden administration will provide even more fiscal stimulus. One of the oldest propositions in economics is that the price level is determined by the demand and supply of money. Simplistic formulations of this proposition are called “ The Quantity Theory “. This proposition states that the rate of inflation is equal to the excess of the rate of growth of money over real incomes – although more sophisticated interpretations take into account other variables such as interest rates and inflationary expectations. But while many investors acknowledge that the huge rise in liquidity in 2020 was being funneled into the stock market, few investors actually feared inflation.
Most noted that the US Federal Reserve had engaged in significant monetary expansion, known as quantitative easing, following the financial crisis. Despite warnings by many economists than of rising consumer prices, inflation did not follow and actually fell.
But there was a big difference between what happened during the financial crisis and what in our opinion is happening now. The money created by the Fed in the past crisis found its way into excess reserves in the banking system. Little of it was lent out to the private sector.
This happened because, before the Lehman collapse, banks did not hold excess reserves. At that time, reserves paid no interest and prudent reserve management dictated that banks keep the absolute minimum to satisfy reserve requirements. All excess reserves were lent into the money market.
The financial crisis changed all of that. Following the crisis, interest rates collapsed.
The Fed started paying interest on reserves and regulators imposed liquidity requirements that could be satisfied with these reserves.
The banks easily absorbed the extra reserves created by the Fed and quantitative easing led to only a modest increase in lending. But the actions of the Fed and treasury in response to the Covid-19 crisis are producing a very different outcome.
The money created by the Fed is not going only into excess reserves of the banking system. It is going directly into the bank accounts of individuals and firms through the US paycheque Protection Program stimulus cheques and grants to state and local governments.
In the mid-1970s, the final years of professor Milton Friedman’s distinguished career he revealed that aggressive expansion of the reserve base was a powerful force and would have saved the US from the Great Depression of the 1930s. But if the expansion of reserves reaches saving and current accounts of the private sector, such Fed action is many times more powerful. Those words informed an optimistic forecast last summer as the pandemic deepened. The US was going to experience a strong stock market in 2020 and in our opinion an inflationary economy in the second half of 2021.
We do not expect hyperinflation or even high single-digit inflation. But we do believe that inflation will run well above the Fed’s 2% target and will do so for several years.
This of course is not good for bondholders. The huge demand for Treasuries, which has kept their yields so low, is driven by their strong short-term hedge characteristics – their ability to cushion sharp declines in risk assets.
But this insurance Is going to get more expensive as higher consumer prices erode the purchasing power of these bonds, It is inevitable bond rates will rise and rise for more than now envisioned by the Fed and most forecasters. The multitrillion-dollar war on Covid-19 was not paid for by higher taxes or bond sales to the public. It will be the Treasury bondholder, through rising inflation, who will be paying for the unprecedented fiscal and monetary stimulus over the past year.
And the warnings that higher inflation lurks around the corner in the United States are starting to show up everywhere. They are appearing in some business surveys, with companies looking to raise prices as they prepare for a post-pandemic economy. They are showing up in the bond market, where price moves in the last few months imply that big-money investors expect consumer prices to start to rise faster. And they are apparent in the news media, whether on magazine covers or in financial news segments.
But inflation itself is not showing up:
The Consumer Price Index in December 2020 showed a rise of only 1.4% in what Americans paid for goods and services over the last year. And top Federal Reserve officials made clear in recent weeks that they – still – viewed too-low inflation as the bigger risk to the economy, not soaring prices.
High inflation causes its own sort of pain, as the purchasing power of money falls. But persistently low inflation is a worry, too, often a reflection of weak growth and stagnant wages – the predominant problem for the United States, Europe, and other advanced economies for more than a decade.
How can one reconcile the inflation talk – and in some quarters, alarm – with the absence of actual inflation? It’s in our opinion easier than you might imagine.
It helps to think, not of a single inflation risk ahead, but of four distinct ones. In terms of significance, these range from mere statistical anomaly to a huge shift in the global economy. In terms of likelihood, they also range from near certainty to completely speculative. Each of these four inflation has different implications, both for how ordinary people making economic decisions should react to them, and how policymakers, particularly at the Fed, should approach their work in the months and years ahead. One of the concerns in our opinion is that policymakers will conflate one inflation risk with another, which could lead to bad decisions, either choking off a recovery prematurely or, on the flip side, allowing a vicious cycle of inflation.
It can be hard to tease these things out in real-time, but some simple metaphors can help. If we start to see higher prices later in the year, the first thing in our opinion to ask is: Is this a yo-yo effect; a story of hungry bears emerging from hibernation; the result of excess water sloshing around a bathtub; or a balloon finally being reflated after years of leaking air?
The spring of 2020 was weird in countless ways. And that means the economic data in spring 2021 will in our opinion also be weird in countless ways.
The price of many goods and services collapsed between March and May last year, as much economic activity shut down. In many cases, those prices have recovered to close – to – normal levels, but in the arithmetic of annual inflation, that won’t matter. Even if the basic trend line of the price of those items is reasonably stable, the reported year-over-year inflation will be extraordinarily high.
If, for example, the overall Consumer Price Index rises through May at a rate consistent with 2% annual inflation, it will show a 3.2% year-over-year rise from the depressed May 2020 level. That would be the highest level since 2011 – but would also be misleading, a result of “ base effects “, rather than the true longer-term trajectory of prices.
For quite a few individual products and services, those numbers will look even more extreme. The price of home natural gas service is on track to be up 5.4%, with airline fares up 16.3%, and the price of women’s dresses up a remarkable 17.9% – all reflecting the deep discounting by retailers in the spring of 2020.
Those numbers might amount to inflation in a technical sense, but only because of the conventions of using year-over-year data. Dress prices in that model may look as if they are evidence of price inflation, but they would still be 9% below pre-pandemic levels.
The most important thing to remember about the yo-yo effect on prices: Beware of anyone who might seek to use these numbers to create misleading narratives about the level of inflation in the economy.
Suppose you get a vaccine jab and suddenly feel more comfortable going out to eat or attending a concert or taking a long-postponed vacation – what would happen if almost everyone emerges from hibernation more or less at once?
There are only so many restaurant reservations, concert tickets, and hotel rooms available; their supply is pretty much fixed in the short run. If anything, the supply is likely to be below pre-pandemic levels because of permanent business failures. That presents a simple Economics 101 situation:: When demand rises sharply and supply falls, steep price increases can result. When suddenly everyone wants to go out again, and there aren’t as many places to go as there used to be, that will in our opinion make companies more comfortable raising prices, as there is a huge demand for limited capacity. That could make prices go up faster than expected, especially as companies try to recoup the cost of dealing with the pandemic.
This possibility is most obvious in service sectors like restaurants, but it could apply to certain goods as well. Suppose all the people who have been working from home for a year in sweatpants need to purchase new work clothes. If retailers and apparel makers haven’t increased supply adequately, they may need to raise prices to avoid shortages.
And this form of price inflation can happen through non-obvious ways, such as a retailer that in normal times routinely offers 20% discounts ceasing to do so.
This, too, is a classic example of the kind of inflationary surge that central bankers need to mostly ignore – to look through to longer-run trends. The Fed can’t create more hotel rooms or dress skirts any more than it can produce more gasoline when a refinery goes down and causes a spike in energy prices. Prices are how the economy adjusts – allocating a limited supply to those willing to pay and encouraging producers to increase supply.
There is in our opinion no way of knowing whether, amid a sluggish vaccine roll-out and continued economic disasters, an emergence from hibernation will take place and whether it will cause this type of spending surge. But if it does, the price spikes that result will be a sign of the economy’s healing, not cause inflationary panic.
And here is a sloshing bathtub number that came out and that you might have missed:
JP Morgan Chase said its total deposits were 37% higher in the fourth quarter than a year before, a rise of 582 billion dollars. It’s a little shocking for what was already the United States’ biggest bank to experience such a vast rise in deposits, but not exactly surprising if you have been following the economic data. From March to November, Americans saved 1.56 trillion dollars more than they did in the same period of 2019, reflecting a pullback in spending combined with federal spending that in the aggregate at least, offset the loss of income from job losses.
And that’s before the 900 billion dollar pandemic aid package Congress passed at the end of 2020, which includes checks of 600 dollars per person for most Americans, and before whatever emerges from President Biden’s plan to spend an additional 1.9 trillion dollar, including a further 1,400 dollar per person. That is in our opinion an enormous amount of money sitting in savings – whether in an account at JP Morgan Chase, physical cash or invested in stocks and other riskier investments. So what happens if everybody starts spending at once?
It is in our opinion entirely possible that as people become more confident in the economy, all that money starts sloshing around, with demand for goods and services outstripping the supply of them. If you have thousands of extra dollars in savings and are increasingly sure that you won’t be losing your job, why not buy a new car or renovate the kitchen?
A similar situation created a very tight job market and remarkable income growth for Americans in the 1960s, but by the end of the decade, inflation was rising, and it would become a major problem in the 1970s.
That makes the potential post-pandemic surge of demand a tricky situation for the Fed and other economic policymakers. In a lot of ways, a broad surge of demand that fuels a boom in economic activity is exactly what the nation has needed – not just since the pandemic struck, but since the Great Recession 13 years ago caused by the financial crisis. After all, if Americans start spending their accumulated savings en masse, companies will need to rush to satiate that demand by building more factories and stores and hiring more workers, creating a boom on the supply side of the economy as well, and higher incomes that come with it. The hope is that we would see a broad-based reflation of the economy, to restore the dollar size of the economy to the trend path it was on before the pandemic which implies higher inflation temporarily and higher incomes.
The Fed will have to decide whether what’s happening is a desirable and long-awaited heating up of the economy or something that’s likely to spill out into sustained inflation, as would happen if consumers and businesses begin to think prices will keep rising indefinitely and act accordingly.
In that situation, the Fed might see a need to raise interest rates sooner than it now expects, trying to stop that cycle but at the cost of cutting off a long-awaited boom.
Over the last three decades or so, the world economy began to work differently. Inflation, interest rates, and growth have fallen persistently in nearly all advanced nations. But now the tides could be reversing. Wages are rising rapidly in China as its economy becomes more advanced, and its demographic outlook is bleak because of the delayed effects of its one-child policy. There is no country anywhere close to China’s size on the verge of integrating into the world economy. And the demographics in advanced nations also suggest in our opinion slow growth or a shrinking workforce over the coming years.
So there is a real possibility that in the 2020s and beyond, the world’s crisis will be too few workers rather than too many – which, all else equal, would mean more upward pressure on wages.
Other forces to watch: The pandemic, the rise of nationalism, and the breakdown of relations between the United States and China could cause de-globalization, which would tend to be inflationary. The US and some other countries may now finally be engaging in deficit spending on a scale that ends an era of inadequate demand.
Any combination of these forces would imply a worldwide reflation of sorts, with prices once again rising and central banks forced to worry about inflation that is too high, rather than too low. The hard part is figuring out whether it’s happening and, if so, what the policy response should be. After all, it took decades for an understanding of structurally low inflation and interest rates to become part of the consensus view of policy elites. Arguably, it’s really taken hold only in the last couple of years.
If this great reflation happens, it will probably be the most important economic story of the 2020s. But if the past is a guide, it will take time to know whether the decade started with a benign yo-yo, a surge of activity after a long hibernation, the soggy results of an overfull tub, or a lasting change in the way the world economy works.