Tuesday, May 19, 2020


The Federal Reserve has poured money into the economy at the fastest rate in 200 years. This has reopened a debate about the re-emergence of inflationary pressures after a decades-long hiatus. 

On the face of it, concerns about long-dormant prices giving way to above-target inflation rates appear farfetched because the United States is experiencing an unprecedented spike in unemployment rates, a record collapse in energy prices, a substantial shortfall in aggregate demand and a drop in the core CPI last month that was the biggest in the history of the index. 

The recent past has been quite unkind to inflation Cassandras. In the aftermath of the 2008 great recession, many predicted that the Federal Reserve’s aggressive policy measures would ignite inflation and may even lead to hyperinflation. Infamously, in a November 2010 open letter to the then-Federal Reserve Chairman Ben Bernanke, prominent economists and investors wrote:

“We believe the Federal Reserve’s large-scale asset purchase plan (so-called ‘quantitative easing’) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation.” The following decade saw actual inflation rates persistently undershoot the Federal Reserve’s 2 percent inflation target. 

Many observers expressing fears of an inflationary spike after the great recession were basing their arguments on an incomplete understanding of inflation dynamics and on a simplistic reading of the textbook money multiplier relationship. Most undergraduate economics textbooks often fail to clarify the nuances associated with the money multiplier relationship.

As noted by LSE economist Charles Goodhart, a former member of the Bank of England’s Monetary Policy Committee, and others, textbook discussions appear to imply an erroneous “behavioral” money multiplier relationship between the monetary base (primarily consisting of currency in circulation and bank reserves) and the money supply. This gave rise to the mistaken view among some that rapidly-expanding bank reserves would lead to a surge in money supply and a follow-up spike in inflation rates. 

In practice, however, the Federal Reserve typically decides on a target for the official short-term policy interest rate (the federal funds rate). The two key ratios — the currency-deposit or C/D ratio and the desired reserve-deposit ratio or R/D — that underlie the money multiplier then determine the appropriate level of monetary base that the Federal Reserve has to create to keep overnight market rates at or near the target level.

This implies that the direction of causation involving the monetary base/money multiplier/money supply relationship is actually the reverse of that implied by a cursory reading of introductory economics textbooks. 

During and after the great recession, the Federal Reserve quadrupled the size of its balance sheet and yet failed to produce any sort of inflationary pressure. As they kept the federal funds rate target in the 0-0.25 percent range between December 2008 and December 2015, both the reserve-deposit ratio and currency-deposit ratio rose substantially, which caused the M1 money multiplier to fall below 1.

A deeper examination of inflation dynamics suggests that structural forces have played a more significant role in keeping inflationary pressures dormant in the U.S. In particular, globalization (global supply chains, offshoring/outsourcing), technological changes (digitization, rise of e-commerce, adoption of online price comparison tools), political trends (decline in the relative bargaining power of labor vis-à-vis capital owners), and demographic shifts have had a major effect in subduing the rate of increase in the price level.

Inflation Cassandras may be proven right this time around. There are at least three reasons to seriously worry about inflation. First, the exploding growth in public-debt levels (driven by fiscal stimulus programs) and the deployment of the Federal Reserve’s balance sheet to aid the non-financial private sector and local and state governments are unprecedented in both scale and scope. 

Given the possibility that U.S. potential growth rate is likely to be subdued for the foreseeable future, there is a growing likelihood that the Federal Reserve will experience some form of fiscal dominance. The Federal Reserve will be under pressure to cap long-term government borrowing costs by engaging in some form of yield-curve control and may even be encouraged to resort to direct financing of federal government spending.

When the Federal Reserve engaged in similar actions in the past (during and after World War II), it gave rise to a period of financial repression and above-average inflation. Politically, the least painful way to reduce high public debt-to-GDP ratio is to sustain above-average inflation rates for a prolonged period in order to gradually reduce the real cost of the debt burden. 

Second, the backlash against China and the shift toward populism observed in both Republican and Democratic circles is likely to result in some unwinding and restructuring of global supply chains. This is likely to reduce efficiency gains and lead to higher prices. 

Third, the imposition of additional barriers to immigration when combined with rapidly aging population in advanced economies will lead to a change in labor market dynamics and in the bargaining power of workers. In fact, a political backlash against growing inequality and anger at inadequate social-safety nets for the working class is likely to lead to higher production costs for domestic firms. 

Unless there is a sustained shortfall in demand that persists into 2021 and 2022, there is a likelihood that long dormant inflationary pressures will reawaken in the medium-term. The Federal Reserve will be willing to let inflation run hot for a while and will not engage in any pre-emptive tightening this time around. 

For investors, and households in general, this will require a rethinking of their consumption patterns and asset-allocation strategies. An entire generation has grown up without any serious exposure to sustained increases in average price levels. One lasting impact of the COVID-19 shock may be the return of high inflation in advanced economies.

• Brian Kench is professor of economics and dean of the college of business at University of New Haven. Vivekanand Jayakumar is associate professor of economics at University of Tampa.

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