Ryan Bourne occupies the R Evan Scharf Chair for the Public Understanding of Economics at Cato, and is the author of Economics In One Virus.
“Inflation is coming” has been the perennial warning of conservative commentators over this past decade. After the financial crisis, it was feared that quantative easing would generate a sharply rising price level. Now, Rishi Sunak is kept up at night by the prospect of an inflation spike. Columns forewarning of one are increasingly common. Even some of the high priests of macroeconomic dovishness, such as Larry Summers and Olivier Blanchard, are sounding the alarm.
s this time different? And how worried should we in the UK be? When thinking through the economics we must unpack three related but different issues: Covid-19 price changes, the overall level of prices, and ongoing “inflation.”
Covid-19 price changes
As the economy reopens, certain sectors will see pent-up demand meet constrained supply. A lot of entertainment venues have gone out of business following a year without activity, for example. A freshly vaccinated public may suddenly be keen to go out and spend after June, despite less capacity in the sector than pre-crisis.
The flexible prices in such industries could therefore see sharp upward price volatility, with new entry taking time to reverse these relative price spikes. The scale will depend on whether demand peaks in a “big bang,” or if there is a gradual transition to whatever “normal” now is. But for a returning public, this will feel very much like a substantial cost-of-living increase.
The Price Level
“Inflation,” though, is “an ongoing rise in the general level of prices.” It is, as Milton Friedman famously said, a “monetary phenomenon,” seen when the money supply increases more quickly than the supply of goods and services. Here, the risks do look different to after 2008.
During the global financial crisis, the money base increased more than four-fold, but broader money supply measures (e.g. M2) barely changed.
Since the beginning of the Covid-19 pandemic, however, not only has the money base increased dramatically, but M2 has increased by over 25 per cent. This hasn’t “stimulated” higher overall nominal spending, since people have been unwilling or unable to engage in certain activities, leading to a sharp fall in money’s “velocity.” As velocity rebounds, extra funds circulating again will likely raise the price level as activity begins (i.e: we will see a “one-off” increase in prices, feeding through over a number of years).
This could see inflation temporarily running above the Bank of England’s two per cent annual target. Indeed, despite current CPI inflation at just 0.7 pe rcent, British macroeconomists believe the forecasts tilt upwards.
Asked which scenario was more likely to hold “on average” for the next decade, 37 per cent of Centre for Macroeconomics economists surveyed said inflation would be on target. But 41 percent said that the Bank of England would either “allow” or “wouldn’t be able to avoid” inflation exceeding its target (just 15 per cent thought inflation would be “allowed” or would inevitably remain below two per cent).
Whether inflation exceeding that two per cent target is considered a “bad thing” really depends on two individual judgments:
- Whether “inflation targeting” is really the appropriate goal for monetary policy, or instead whether a level target for prices or nominal GDP is preferable, and;
- Whether a period of significant inflationary pressure could or would be swiftly eliminated by the Bank of England afterwards without negative consequences.
The UK experienced a very dramatic collapse in nominal GDP last year, including a fall in inflation below the Bank’s inflation target. If one believes optimal policy maintains steady increases in the price level or in the level of nominal GDP over time, then a post-crisis overshoot of the inflation target in the service of returning to trend may be desirable. The Bank wouldn’t therefore need to drastically adjust policy, but could “look through” this price level uplift, aiming for the two per cent inflation target in the longer term.
What would obviously be problematic is were the broader money stock to continue growing faster than trends in nominal GDP or desired inflation, generating sustained higher inflation. Few doubt the Bank of England would have the tools to choke this off.
So the questions that arise from this possibility really are,
- How much damage would be done if above-target inflation altered inflation expectations in the interim? an
- Would the Bank of England be willing to bring inflation back to target even if it meant the government’s debt service costs spiking?
Economists such as Summers, scarred by the 1970s and early 1980s, believe it “naïve” to think the alternative to a low inflation world is a modest inflation world with the promise of future low inflation.
Playing with significantly above-target inflation for a time can instead help create a high and variable inflation world. If people feel and so come to expect higher inflation, they start shortening contracts, demand cost-of-living adjustments, alter the balance of their portfolios away from non-interest bearing assets, and delay certain investments. This can make the economy less efficient, and entrench the combination of slow growth and high inflation.
It previously took painful efforts to “re-anchor” inflation expectations and cement central banks’ monetary credibility. So is this credibility at risk again?
There have been some recent jitters, but as yet little sign of widespread concern here. Inflation expectations jumped swiftly to 3.8 pe rcent in December, but have since fallen back to normal levels. Expectations implied by inflation-protected gilts predict inflation will exceed its target over the coming decade, but again are not historically abnormal. Recent increases in gilt yields are more likely to reflect the expectation of a more robust recovery than large inflation concerns.
Obviously, we should be cognisant of fears of how high government debts, or political pressures to change central bank mandates, can corrupt price stability. Certain historic episodes have led to “fiscal dominance,” with central banks prioritising keeping governments’ debt servicing costs low over price stability. The U.S. has officially changed its mandate with an asymmetric bias towards lower unemployment. Any change to the Bank of England’s official mandate, or even just prolonged above-target inflation, could risk fears of monetary policy here being driven by fiscal concerns about debt servicing costs or 1970s-style desires to try to push unemployment lower too.
But as yet, again, should the UK doubt its institutions? Andrew Bailey hasn’t said anything suggesting that the Bank would ignore sustained inflation. The Chancellor, if anything, is too eager to close the deficit through damaging business tax hikes because he fears the inflation risk—something that paradoxically could worsen near-term price level pressures by choking off investment in productive capacity as spending rebounds.
All this means that I think the current fears are overblown. But, yes, the broader context requires longer-term vigilance – the balance of risks on inflation, driven by economic and political trends, has definitely shifted.