Will inflation make a comeback? - Capital Economics
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Will inflation make a comeback?

Global Economics Focus
Written by Vicky Redwood
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Although low inflation is likely to be the story over the next couple of years, the huge amount of policy stimulus could push up inflation further ahead. Central banks, in theory, have the tools to nip any rise in the bud. So the bigger risk is if there is an institutional slide towards accepting, or even welcoming, higher inflation. Among the major developed countries, these risks seem greatest in the US and perhaps the UK.

This Focus forms part of a series exploring how the coronavirus pandemic will change the global economy. You can find other publications in this series here.

  • Although low inflation is likely to be the story over the next couple of years, the huge amount of policy stimulus could push up inflation further ahead. Central banks, in theory, have the tools to nip any rise in the bud. So the bigger risk is if there is an institutional slide towards accepting, or even welcoming, higher inflation. Among the major developed countries, these risks seem greatest in the US and perhaps the UK.
  • Vast amounts of (digital) “money printing” by central banks have prompted commercial banks’ reserves to rocket. Worries that this will spark a boom in bank lending are overdone. Even so, central banks’ asset purchases, along with emergency bank lending programmes, are directly boosting the money supply. By the end of 2021, we think that broad money as a share of GDP will be at least a fifth above its pre-virus level in the US, UK and euro-zone.
  • Crucially, the big fiscal giveaways mean that this money is ending up in the hands of those most likely to spend it (i.e. firms and households). This is very different to the quantitative easing seen after the financial crisis, when fiscal policy was more restrained and the money ended up stuck in the financial sector.
  • Still, the links between money growth, demand and inflation are not automatic. Uncertainty about the virus means that firms and households will want to hold higher precautionary cash balances for some time. Even if they do spend the money, there is likely to be spare capacity for a while to prevent inflation rising. But once these factors fade, then the extra demand could fuel inflation. The extent of this would depend on factors such as the strength of workers’ bargaining power and the stability of inflation expectations.
  • At most, we think that inflation could be boosted by 2pps to 3pps per annum for several years. This would hardly be disastrous relative to the double-digit rates of inflation seen in many economies in the 1970s and 1980s. And assuming that the current policy stimulus is a one-off, then the rise in inflation should be temporary too. Moreover, central banks have the tools to nip any rise in inflation in the bud, namely reversing the rise in the money supply (i.e. quantitative tightening) and raising interest rates.
  • However, there are two risks. The first is that central banks simply get it wrong; they try to stop inflation but act too late. Indeed, the last period of high inflation in major developed economies, the “Great Inflation” of the late 1960s and 1970s, was accidental rather than a deliberate strategy.
  • The second is that there is an institutional slide towards accepting, or even encouraging, higher inflation. Some governments might keep running substantial (inflationary) deficits even after the crisis; some might seek to inflate away their debt; and some might put pressure on central banks to keep interest rates and the costs of servicing their debt low. Of course, monetary policy was devolved to independent, inflation-targeting central banks precisely to prevent governments allowing inflation to rise for their own benefit. But the current inflation-targeting regimes are not set in stone; the current shift towards “average inflation targeting” (enabling an overshoot of the inflation target) could prove to be the thin end of the wedge.
  • Inflation risks are particularly high in countries where central banks are vulnerable to political pressure and where government debt burdens look unsustainable (in both cases, mainly emerging markets). Among developed countries, inflation risks are highest in the US and perhaps the UK, as we can imagine both running permanently bigger fiscal deficits after the crisis. Risks are lower in Japan, given low inflation expectations are so entrenched, and the euro-zone, given its institutional structures. Indeed, it is possible that later this decade, there could be a period of divergence in inflation rates in the major developed economies not seen since the early 1980s and early 1990s.

Will inflation make a comeback?

This Focus forms part of a series exploring how the coronavirus pandemic will change the global economy. You can find other publications in this series here.

The huge amount of stimulus that policymakers have provided has certainly been the right thing to do. But it has also led to fears that a sharp rise in inflation is around the corner once economies recover. In this Focus, we put the stimulus into perspective and discuss policymakers’ role in determining whether this becomes a serious inflationary threat. We concentrate on the major developed markets, where the amount of money injected into the economy has been most striking. After almost three decades of low inflation, could we about to enter a new era of high inflation?

A huge, two-pronged stimulus

There are two key facts about the recent stimulus that mean it has big inflationary potential. The first is that it has combined a big fiscal stimulus and big central bank asset purchases. We shall see later why this is so important. And the second is the sheer scale of both. The rises in fiscal deficits have generally dwarfed the size of those seen after the global financial crisis. The US, for example, will this year run its biggest ever peacetime deficit. (See Chart 1.)

Chart 1: US Government Balance (% of GDP)

Sources: Maddison, Capital Economics

Similarly, central bank asset purchases have generally been on a scale not seen before. Chart 2 shows that the monetary base, or M0, as a share of GDP in the UK has far surpassed the level seen after the financial crisis, which was already the highest since data began in 1840. (See Box 1 for a quick refresher on different measures of the money supply.)

Chart 2: UK Monetary Base (As a % of GDP)

Sources: Bank of England, Capital Economics

Even going back further, it has been rare to see this powerful a stimulus. That is particularly true of past pandemics, which have generally produced little in way of a policy response. This reflects a variety of institutional and structural constraints, including the smaller role of the state and frameworks like the Gold Standard that prevented a significant loosening of monetary and fiscal policy. 

Box 1: Measuring the money supply

The narrowest measure of the money supply is so-called M0, often referred to as the monetary base. This consists of currency in circulation, together with commercial banks’ reserves with the central bank.

The other measures of the money supply (M1, M2, M3 and M4) include currency in circulation (but not commercial banks’ reserves) and other components of money. The higher the number, the broader the measure of the money supply.

M1 is restricted to the most liquid forms of money (akin to money’s function as a medium of exchange). In addition to currency in circulation, this includes overnight deposits i.e. deposits which can immediately be converted into cash or used for cashless payments.

M2 is a boarder measure which approximates money’s function as a store of value and includes M1 plus savings deposits. These savings deposits can be converted into components of narrow money, but some restrictions may apply, such as the need for advance notification, penalties and fees.

M3 and M4 are even broader measures that include M2 plus items that many regard as a close substitute for money, such as short-term repurchase agreements and institutional money market funds.

Monetary base soars

It is the (digital) “money printing” by central banks that raises the biggest inflationary eyebrow, so let us start there. Central banks’ actions, whether through quantitative easing (QE) or the various liquidity programmes, have already hugely boosted the monetary base in the US, UK and euro-zone. Japan has seen a relatively small rise. (See Chart 3.)

Chart 3: Monetary Base (Jan. 2008 = 100) (Latest = July)

Source: Refinitiv

The monetary base consists of two components: notes and coins in circulation and commercial banks’ reserves at the central bank. It is the latter which have surged (as Chart 4 illustrates for the US). This is because these reserves are credited every time that the central bank makes a loan or buys an asset.

Chart 4: US Components of M0 ($bn) (Latest = week beginning 12 August)

Source: Refinitiv

Some of this rise in the monetary base will quickly be reversed as short-term emergency liquidity measures expire. (Chart 4 shows that this is already happening in the US. See here.) However, most is unlikely to be reversed soon. In fact, we think that most central banks will expand their quantitative easing programmes further. If we assume that the monetary base grows in line with our forecasts for central banks’ asset purchases, then Chart 5 shows that it has much further to rise. By the end of next year, we think that it will end up double its pre-crisis level in the UK, and not far off that in the US. We expect the UK to endure a more sluggish recovery than most, hence our forecast for so much more QE there. (See here.)

Chart 5: Monetary Base (Jan. 2008 = 100)

Sources: Refinitiv, Capital Economics

Bank lending surge unlikely

One of the biggest inflationary fears is that this will lead to an explosion in bank lending if banks increase their lending to the private sector on the back of this rise in reserves. Traditional “money multiplier” theory assumes that, under a fractional reserve system, banks “multiply” up their level of reserves into a bigger change in loans and deposits.

But we can knock this fear on the head quite quickly. Bank lending is not determined solely by how many reserves banks have. This is evidenced by the fact that lending did not respond to the surge in reserves following the large amounts of QE after the financial crisis. As Chart 6 shows, the money multiplier (the ratio of broad money to narrow money) fell sharply in 2008 and has stayed low since.

Chart 6: Money Multiplier (M3/M0) (Latest = July)

Sources: Refinitiv, Capital Economics. Throughout the Focus, we use our own measure of US M3, since the official one has been discontinued.

Indeed, other factors will limit the amounts banks lend, such as constraints on bank capital, regulatory requirements and whether there are profitable opportunities to lend (including whether people want to borrow).

Admittedly, the growth of bank lending has accelerated sharply since the start of the coronavirus crisis, reflecting a sharp pick-up in lending to private non-financial companies. (See Chart 7.) But this just reflects firms drawing down emergency credit lines or using government support programmes and is likely to be temporary. Indeed, lending growth has already begun to slow again in most countries.

Chart 7: Lending to Private Sector (% y/y) (Latest = July)

Source: Refinitiv

Broad money growth accelerating fast

Nonetheless, even without a rise in bank lending, central banks’ asset purchases will still feed through to a rise in the broad money supply. When central banks buy government bonds from domestic non-banks, they credit the bank accounts of these institutions with more money, resulting in an immediate and equivalent rise in broad money.[1]

Together with the pick-up in bank lending growth, this means that broad money growth has already risen sharply. (See Chart 8.) We use the M3 measure for consistency between countries, though note that countries differ slightly in how they define M3. The July figures showed M3 rising at annual rate of 9.7% in the euro-zone, 10.9% in the UK and a whopping 23% in the US, the highest rate since the US M3 data began in 1959. The faster rate in the US primarily reflects its more generous bank lending schemes.

Chart 8: M3 (% y/y) (Latest = July)

Sources: Refinitiv, Capital Economics

Chart 9 puts this growth into an even longer-run context for the US and UK. For the US, M1 is the only measure of the money supply that has a long back-run. This is not ideal, as it includes checkable but not savings deposits, and so can be distorted by swings between the two as interest rates rise and fall. But for what it is worth, July’s 38%annual rise in US M1 was the biggest peacetime increase since records began in 1850. In the UK, there is a long-run series for M4; money growth is high, although not as high as the 20% or so rates seen in the 1970s/80s.

Chart 9: Broad money (% y/y) (Latest = July)

Sources: Maddison, Bank of England, Refinitiv

All of this will leave the ratio of money balances to GDP much higher than they were before the crisis. Chart 10 shows that, on the basis of our forecasts for central banks’ asset purchases, M3 as a share of GDP by the end of next year will be around a fifth higher in the US and euro-zone than it was at the end of 2019, and around a quarter higher in the UK. In Japan, where the policy stimulus has been more moderate, it will end up about a tenth higher.

Chart 10: M3 as a % of GDP

Sources: Refinitiv, Capital Economics

Money ending up in the right place

But this is not the end of the story. We stressed at the outset that what rings potential inflationary alarm bells is the fact that this money-printing has been combined with a big fiscal stimulus. We have explained elsewhere that the current situation effectively amounts to debt monetisation. (See here.) Crucially, this means not only that the money supply is rising sharply, but that this rise in money will end up in the hands of those most likely to spend it.

The financial institutions that have bought bonds from the government and sold bonds to the central bank have essentially just acted as a go-between. So the money printed by the central bank has ultimately gone to the households and firms who have been recipients of the fiscal giveaways. Indeed, the magnitudes of the money printing and the fiscal stimulus have generally been very similar so far.

This is a crucial way in which this episode differs from the QE after the global financial crisis. Many people point to that episode as proof that large amounts of QE don’t fuel activity or inflation. The monetary base expanded sharply on the back of large QE programmes by central banks, yet inflation showed no noticeable pick-up. (See Chart 11.) Indeed, despite having the sharpest rise in asset purchases, Japan is still struggling to break away from deflation. (See here for more discussion of Japan.)

Chart 11: CPI Inflation (%)

Source: Refinitiv

But there is a crucial difference between then and now, namely that fiscal policy back then was not being loosened at the same time as QE. Other than during the first few months, QE was accompanied by falling government borrowing (both in total and cyclically-adjusted terms) in the US, UK and Japan, and broadly stable borrowing in the euro-zone. (See Chart 12 for the US.)

So although QE still provided a direct boost to the money supply, this money got lost in the financial sector. Accordingly, the only way in which QE was ever going to boost activity and inflation was via the financial sector – for example, the investors who had sold bonds to the central bank rebalancing their portfolios by buying other assets and pushing asset prices up and borrowing costs down. Even if such channels did work, the effect was mainly to boost asset, rather than consumer, prices.

Chart 12: US Monetary Base & Government Deficit (As a % of GDP)

Sources: Refinitiv, Capital Economics

Indeed, we can already see the difference between now and the post-financial crisis episode in what is happening to corporates’ and households’ deposits. Chart 13 uses the UK to illustrate this. Households and non-financial firms saw no discernible change in their money holdings during the main periods of QE in 2009/10 and 2012/13 (shown by the dotted circles). By contrast, their money holdings have risen sharply in the past couple of months. The rise in the money supply that we expect by the end of 2021 is equivalent to around a third of households’ and non-financial corporates’ combined holdings in the UK and euro-zone, and around a fifth of those in the US.

Chart 13: UK Money Holdings (Monthly Change, £bn)

Source: Refinitiv

A better comparison for the current situation is arguably with the 1970s and early 1980s. Then, money growth also rose rapidly. Between 1973 and 1982, annual broad money growth averaged 11% in the US and 15% in the UK. Moreover, like now, this growth was seen in the money holdings of non-financial firms and households. Government deficits played some role in this. But also important was bank lending; annual growth of bank lending averaged 11% in the US and 17% in the UK. Accordingly, the money ended up in the hands of firms and households. And inflation did result; over the same period, it averaged 9% in the US and 14% in the UK. (See Chart 14 for the US.)

Chart 14: US M3 & CPI Inflation

Sources: Refinitiv, Capital Economics

Admittedly, the scale of the rise in the money supply was far bigger then. Broad money tripled in the US and quadrupled in the UK. But we will discuss later the circumstances under which this episode could also turn into something more significant.

The murky links between money and inflation

So money growth has risen sharply and that extra money has gone to those most likely to spend it.

Contrary to what traditional monetarists would have you believe, the link between money growth and inflation is still not automatic. For inflation to result, faster money growth would need to give a big boost to demand for goods and services and this extra demand would then need to fuel inflation. But neither seems likely in the near term.

For a start, uncertainty about the virus means that firms and households will want to hold higher precautionary money balances for some time yet. During the crisis, the velocity of circulation (the ratio of GDP to broad money) has fallen sharply. (See Chart 15 for our estimate for the US.) We doubt that this will suddenly rebound, even as lockdowns ease.

Chart 15: US Velocity of Circulation (GDP/M3)

Sources: Refinitiv, Capital Economics

Even if money growth boosts demand, there will be spare capacity in the economy for a while that will prevent inflation rising. We expect aggregate demand to recover more slowly than supply and core inflation still to be subdued at the end of 2022. (See Chart 16 & our Global Inflation Watch.)

Chart 16: Core CPI Inflation (%)

Sources: Refinitiv, Capital Economics

But at some point, uncertainty surrounding the virus will fade and the economy will return to full employment. Then, the risk of a rise in inflation as firms and households seek to reduce their excess money balances will be rather higher.

Whether this risk materialises depends on various factors. One is the size of the excess money balances at this point. People could just sit on their money for long enough for economies to grow sufficiently in the meantime simply to absorb these excess money balances. That said, this would take a while. Suppose that the level of broad money in the US flattened off at the end of next year. If nominal GDP were to grow at its average rate in the pre-virus decade, then the gap between broad money and GDP would close by around 2026. (See Chart 17.) Under a perhaps more realistic assumption of broad money growing at a (still modest) annual rate of 2%, it would take until around 2030 for this to happen.

Chart 17: US Levels of M3 & GDP ($bn)

Sources: Refinitiv, Capital Economics

Another factor to consider is how firms and households seek to reduce their excess money balances. If they spend them on goods and services, then this will boost aggregate demand. But they might instead use them to repay the emergency credit lines they drew down as a precaution during the crisis and/or repay other debt. This will partly depend on the distribution of the excess money balances. They are most likely to be inflationary if they are concentrated in households, especially households with a higher propensity to consume.


And finally, there is no exact relationship between aggregate demand and inflation. In open economies, some of the resulting rise in aggregate demand would just result in more imports being sucked in. Inflation might also be less likely to pick up in countries where the so-called Phillips Curve (the relationship between activity and inflation) is weak, perhaps due to the stability of inflation expectations or weak bargaining power of labour. There might also be some offsetting downward pressure on inflation from other factors. For example, we have argued elsewhere that the coronavirus crisis could be the trigger for a rise in investment in the digital economy that boosts productivity growth and therefore puts downward pressure on unit labour costs and inflation. (See here.)

Accordingly, there is no straightforward way to predict what inflation might do further ahead. But to give a ball-park upper estimate, suppose that, come 2023, economies are broadly back to “normal”, any output gaps have been eliminated and firms and households spend all of their excess money holdings. On our estimates, these would be equivalent to between 10% and 15% of GDP at this point. The resulting boost to aggregate demand in the major developed economies would have the potential to boost inflation by around 2 to 3 percentage points per annum for around five years. (Using the quantity theory of money of MV=PT i.e. money supply x velocity of circulation = price level × transactions or output.) So an economy that usually experiences inflation of about 2% would instead see inflation of 4% or 5% for a few years.

This would hardly be disastrous relative to the double-digit rates of inflation that were seen in many economies in the 1970s and 1980s. And if we assume that the current policy stimulus is a one-off, then the rise in inflation should be temporary too.

However, there are three ways in which this could all morph into a more sustained rise in inflation. The first is if the initial rise boosted inflation expectations and kicked off a wage-price spiral. The second is if we are wrong about bank lending, and in fact it does take off on the back of the sharp rise in commercial banks’ reserves.

And the third is if the policy stimulus does not prove to be a one-off after all. Take the UK, for example, where we expect virtually of the government’s debt issuance to be hoovered up by the central bank over this year and next, and the broad money supply to be around 25% higher at the end of 2021 than at the end of 2019. Thereafter, imagine that the government ran an annual deficit of, say, 10% of GDP and that the Bank of England kept funding it all by money printing. In that case, the broad money supply by 2025 would be 50% higher than its end-2019 level, and by 2030, about twice as high. That would be on a par with the expansion in the money supply seen between 1974 and 1980.

Inflation could be stopped… in theory

At least policymakers, in theory, have the tools to nip any rise in inflation in the bud.

For a start, central banks could reverse the rise in the money supply – or measures to that effect. Most obviously, they could reverse the asset purchases by buying the assets back i.e. switching from quantitative easing to quantitative tightening. This would extinguish the rise in commercial banks’ reserves and the rise in broad money that accompanied it.

If they were worried about the upward impact this would have on government bond yields, central banks could shrink the monetary base by other means. For example, they could use reverse repos (where they sell assets to the banks and commit to buying them back in the future) or sell central bank sterilisation bills. These would drain some of the reserves held by banks, without having to sell government bonds. They could also impose special deposit requirements on banks, effectively freezing their reserves. For instance, in the early 1960s most US banks had to keep as much as 18% of their deposits in reserve.

As we stressed earlier, there have been two components to this stimulus – the money printing by central banks, and the fiscal stimulus by governments which has redistributed money from financial institutions to firms and households. The measures discussed so far deal with the first element. As for the second, governments could raise taxes and/or cut spending to make people “pay the money back”. In turn, government bond issuance would fall and money would get “redistributed” back to investors. But it seems highly unlikely that most governments would do this, especially given that low interest rates will enable most governments to carry their higher levels of debt quite easily. So to offset the inflationary effects of the permanent fiscal stimulus, central banks would need to raise interest rates too.

An institutional slide towards higher inflation?

But just because a rise in inflation could be stopped does not mean that it would be stopped. There are two main risks.

The first is that central banks might simply get it wrong. They could want to stop the rise in inflation but act too late. Such a policy error would occur if policymakers were taken by surprise by the speed at which inflationary pressures built up and failed to deploy their tools quickly enough.

Indeed, it is worth noting that the major inflationary periods in recent history – namely the period of high inflation after the Second World War and the “Great Inflation” of the 1970s – were not deliberate. (These episodes are shown in Chart 18 for the US and UK.) The episode of high inflation after the Second World War primarily reflected the lifting of wartime price controls. As for the 1970s, there are various theories about why policymakers allowed inflation to get so high, but they all essentially relate to policy mistakes – including mistakenly still believing in a trade-off between unemployment and inflation; failing to realise that trend GDP growth had fallen and therefore mis-estimating the output gap; and thinking that inflation triggered by non-monetary factors, such as higher oil prices, could not be brought down by monetary policy.

Chart 18: US & UK CPI Inflation (%)

Sources: Bank of England, Maddison

Another way in which high inflation might become entrenched is if there were an institutional slide towards accepting, or even encouraging, high inflation.

It is easy to see why governments, in the current circumstances, might want to go down this route. For some, higher inflation might seem like an easy way to reverse their rise in public sector debt. Admittedly, we have explained in other work why most countries will be able to tolerate their higher debt levels, especially if they can use financial repression (measures to artificially lower bond yields) to help them do so. (See here.) We have also explained elsewhere why high inflation might not actually reduce debt burdens by that much, and that even if it did, the benefits might be outweighed by the other costs that high inflation brings. (See here.) Indeed, as we pointed out above, although it might look like governments engineered inflation in the past to erode debt burdens (such as after the Second World War), high inflation was more accidental than deliberate. Nonetheless, governments might be seduced by the apparent quick-fix of high inflation, especially given the unappealing alternatives in some cases of austerity or default.

For other governments, high inflation might seem like a price worth paying to keep running deficits even after the crisis is over. Some might succumb to pressure to keep support programmes running indefinitely. Some will be under pressure to raise spending on health services. And some may simply see the “magic money tree” that paid for the coronavirus crisis as a route to finance all sorts of other objectives. Some governments might also put pressure on central banks to keep interest rates low (regardless of the impact on inflation) to ensure that the costs of servicing their already high level of debt stay low.

Of course, the reason that so many central banks were made independent in recent years was precisely to prevent such scenarios. Indeed, we have explained elsewhere why the effective financing of government spending by central banks this year does not need to get out of control or have inflationary consequences, so long as an adequate institutional framework is in place. This would allow a central bank to stop monetising government debt when it wanted. (See here.) On the face of it, then, the chances of a shift to a high-inflationary era would seem to be far less than in the past when governments exerted much greater control over monetary policy.

But it may be that central banks also take a deliberately more lax approach to inflation. Their existing inflation-targeting frameworks are not set in stone and have become increasingly flexible since they were introduced. The latest shift, being led by the US Fed, is towards “average inflation targeting”, the idea being that central banks should aim to achieve their objective on average over a period of time, such as a whole economic cycle. This paves the way for a period of overshoots of inflation targets after the current undershoots. (See here.)

That could turn out to be the thin end of the wedge. After all, the current inflation-targeting regime has clear shortcomings. We could eventually see a more fundamental shake-up of inflation-targeting – framed by governments and central banks as improving the conduct of monetary policy, but with the result nonetheless being higher inflation. This might include a rise in the inflation target itself (which many argue would help to get around the problem of official nominal interest rates running up against the zero lower bound). Alternatively, we have previously argued for some sort of change in the monetary policy regime that would allow central banks to operate with a wider inflation target in order both to acknowledge the difficulty of targeting precise inflation rates and to put more weight on other factors (like financial stability). (See here.)

It may be hard to imagine a shift to a high inflation era now, when inflation has been low for so long. But when there have been major shifts in the inflationary environment before, whether from low to high inflation or vice versa, expectations were generally slow to adjust, precisely because people and financial markets were too influenced by what had happened recently.

Where are the risks greatest?

The risks of inflation are arguably biggest in those countries where governments have the greatest incentive to allow, or encourage, inflation. This includes those whose public sector debt after the crisis will be on an unsustainable path and who view higher inflation as preferable to the other options of austerity or default. For now, this group includes hardly any countries, but it could grow if countries struggle to reduce their debt burden by other means (to include, for example, Brazil and South Africa). It also includes governments that are most likely to continue running deficits even after the crisis, which we think includes the US and UK.

Inflation risks are also highest in countries where central banks are most likely to allow higher inflation. This includes those countries where central banks have limited independence and they are vulnerable to political pressure. These are most likely to be emerging markets. India is a good recent example; political pressure from the government culminated in 2018 in the resignation of the Governor of the RBI and the appointment of a government ally. (See here.) But it also includes countries where monetary policy frameworks might be adapted to permit higher inflation – with the US again potentially fitting the bill.

Inflation risks are lower in Japan and the euro-zone. Both seem likely to try to bring fiscal deficits down after the crisis – Japan because of its already very high level of public sector debt and the euro-zone because of the monetary union’s fiscal rules. Admittedly, these fiscal rules have been suspended in the euro-zone for this year and will not be re-imposed next year; but we doubt that they will be abandoned indefinitely given the need for fiscal discipline in the single currency area and the strong preference in Germany and other northern economies for prudent fiscal policy.

Moreover, stubbornly low inflation expectations will continue to play a key role in Japan. And in any case, the rise in Japan’s central bank balance sheet during this crisis has also been smaller than in other major developed economies. (See here for more on Japan.) Meanwhile the constraints of monetary union will bear down on inflation in the euro-zone; if an individual country like Italy, for example, wanted to inflate away its debt, it has no independent control over its monetary policy to do so. Moreover, the ECB has a history of tightening policy too early rather than too late. (See our forthcoming European Economics Focus for more.)

Accordingly, we could end up with a divergence in inflation rates among the major developed economies. Such a divergence is not unprecedented. But the last time a major one was seen was in the early 1980s. (See Chart 19, which shows the difference between inflation rates in the major developed economies with inflation in Germany.)

Chart 19: CPI Inflation (% point difference with Germany)

Source: Refinitiv

Conclusions

Any inflationary threat is still years away. Low inflation is still likely to be seen in the near-term. Further ahead, though, the picture could be very different. This depends both on the impact of the large amount of money that has been pumped into economies and how policymakers’ attitudes towards inflation evolve post-coronavirus.

We think that there are broadly three possible scenarios. The first is that the huge policy stimulus does nothing to inflation, just as the QE after the financial crisis did nothing. Eventually economies just grow into their higher money balances. This may be the case for Japan, where the rise in the money supply has been relatively small and the structural forces bearing down on inflation are very strong. For some other major developed economies, though, the inflationary potential of the recent stimulus seems higher.

Suppose that an inflationary threat did emerge. Then there are two possible outcomes. The first is that policymakers manage to head it off by tightening policy. Interest rates would therefore probably rise faster in the second half of this decade than financial markets think. Even with financial repression, government bond yields (and yields on other assets) would rise more quickly than most assume. The other scenario is that policymakers allow inflation to rise, whether accidentally or deliberately. In that case, we would be on the brink of a transition to a new – and largely unanticipated – inflationary era.

Different countries may end up going in different directions. Whereas a sustained shift to permanently higher deficits seems unlikely within the constraints of the euro-zone, it would be much easier for this to happen in the US and UK. In fact, the US was running significant fiscal deficits even before the coronavirus hit. If we do see the low-inflation era in developed economies draw to a close, it seems most likely to happen first in the US, and perhaps the UK.


Vicky Redwood, Senior Economic Adviser, victoria.redwood@capitaleconomics.com

  1. Note that the broad money supply does not rise if central banks buy bonds from banks, as banks are just swapping bonds for reserves at the central bank. In other words, they are just changing the composition of their assets. Similarly, if central banks buy government bonds from non-residents, the broad money supply does not rise either.