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How long will the bad inflation news last?

Like other central banks, the US Federal Reserve has been complacent about inflation risks. The complacency was challenged by the 12 May announcement that the increase in the consumer price index was 4.2% in the year to April. Will US consumer inflation exceed 5% and, if so, when? And will the inflation increase prove temporary, persistent, or even permanent?

The next CPI release is on 10th June and will relate to May. In May 2020 the CPI fell by 0.1%. So an increase in May 2021 of 0.7% or more would take the annual rate to 5%. The average monthly increase in the CPI so far this year has been just above 0.6%, while business surveys indicate price-raising pressures are at their most intense for over a decade. Evidently, there is a possibility that the annual rate of consumer inflation will soon go above 5%.

As discussed in this video, the increases in the CPI were quite large in mid-2020, but then negligible (with an average monthly increase of half of 0.1%) in the last four months of the year. A good bet is that – if the annual rate does not exceed 5% next month – it will do so before the end of the year. (I discuss these developments in more detail in a recent article in The International Economy magazine).

In these e-mails the emphasis of the inflation discussion in 2020 and early 2021 was on asset price buoyancy and the remarkable surge in commodity prices from April 2020’s trough. But news is now emerging of big wage increases. McDonalds has raised pay by 10%, in order to recruit enough staff to deal with an anticipated boom in demand when lockdowns end. Meanwhile the Bank of America plans to add 25% to its minimum hourly wage between now and 2025. The labour market is tight. As the Covid-19 restrictions are relaxed and more people return to work, it will tighten further. Upward pressures on costs and prices will become even more general.

The Fed chair, Jay Powell, believes that it is his institution’s task to deliver ‘full employment’ and seems concerned that US employment is still several millions lower than in early 2020, ahead of the Covid-19 devastation. No one seems to have told him:

  • first, that the stability of the Great Moderation is often attributed to the argument that no long-run trade-off exists between unemployment and inflation, and,
  • second, that this argument leads to the prescription that central banks should concentrate on price stability.

Further, his research staff have evidently failed to explain to him that a monetary explanation of national income and the price level – in which inflation is determined mostly by the excess of money growth over the increase in real output – has a long and distinguished pedigree in macroeconomics.

Anyhow the answer to the question, “will the US inflation increase prove temporary, persistent or even permanent?”, depends on current and future rates of growth of the quantity of money, broadly defined. To recover the macroeconomic stability and negligible inflation of the 2010s, it is necessary for that rate of growth to be brought down to about 0.3% a month.

Two main difficulties need to be highlighted.

First, US banks are now keen to expand their profitable loan assets and to reduce the excessive ratio of unremunerative cash reserves to total assets. With M3 broad money at about $26,000 billion, increases in banks’ loan portfolios of $100-150 billion a month by themselves add about 0.5% to the quantity of money. (This assumes – perhaps wrongly in current circumstances – that banks finance the new loans by adding the same amount to their deposit liabilities. As just noted, they may reduce the ratio of cash to assets instead.)

Second, the Federal deficit is widely expected to reach $3,000 billion in the 2021 calendar year, or about $250 billion a month. Again, if that is financed to the extent of $100-150 billion a month from the banking system, the quantity of money rises by about 0.5%. On the face of it, US policymakers will not find it easy to restrain money growth to the low figures that are consistent with inflation of under 2%.

While the USA may have trouble over the next few years in dampening money growth and restoring low inflation/price stability, China is veering towards credit restriction. China has become far more authoritarian under Xi Jinping, while his Harvard-educated top economic adviser, Liu He, is reported to dislike excessive debt. In the three months to April, M3 went up by only 1.8% (or at an annualised growth rate of 7.6%). Annual money growth of little more than 5% would be the lowest since China’s opening to the world began after the death of Chairman Mao in 1976.

 

Professor Tim Congdon, CBE, is Chairman of the Institute of International Monetary Research at the University of Buckingham, England.

Professor Congdon is often regarded as the UK’s leading exponent of the quantity theory of money (or ‘monetarism’). He served as an adviser to the Conservative Government between 1992 and 1997 as a member of the Treasury Panel of Independent Forecasters. He has also authored many books and academic articles on monetarism.

 

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