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Are we again crying wolf on inflation risk in pandemic response?

Now is too soon to worry about inflation from a public policy perspective given the immediate humanitarian need for disaster relief. Many millions of newly unemployed people need cash now to pay bills and just to buy food for themselves and their families. Hesitating to provide help now because of worries about inflation later would be beyond the pale.

Now is too soon, also, to expect to see a rising Consumer Price Index (CPI). Rising unemployment and precautionary savings are currently exerting downward pressure on inflation. Longer term, however, exploding deficits, soaring debt levels, and money printing raises the risk of a toxic bout of inflation. Investors should consider the opportunity provided by declining inflation expectations to diversify into newly cheap inflation-hedging assets.

Falling employment is deflationary

A shocking number of people are losing their jobs. Approximately 17 million people across the United States filed for unemployment insurance during the three weeks ended 4 April 2020, representing almost 11% of the 150 million people working in the US in March (FRED, 2020). Add expected new claims for the week of April 11, and the unemployment rate is likely near 15% and climbing fast. Layoffs and furloughs will continue in coming weeks.

In Australia, the Treasurer Josh Frydenberg has conceded that unemployment will rise to 10% in the three months to June 2020, up from 5.1% in February. The sight of long queues of newly unemployed people at Centrelink offices was a major factor in the massive size of Australia’s stimulus package.

When people lose their jobs, they must immediately cut back discretionary spending. More important, those who keep their jobs reduce spending to increase precautionary savings. This sudden decline in spending reduces aggregate demand more than aggregate supply and thereby puts downward pressure on the prices of goods and services.

Exploding deficits

We must act. Fiscal stimulus is a necessary humanitarian effort to keep our economy functioning through this COVID crisis. By propping up aggregate demand, we aim to prevent a larger than necessary decline in economic output. Failing to do so would risk a depression and profound human suffering.

When tax receipts tumble and government spending soars, deficits explode. Consider tax collections. Income and employment tax receipts are falling alongside declining employment. Sales tax receipts are falling in line with lower spending. Capital gains tax receipts are falling because stock prices have dropped.

How much new debt will be created in the US? Goldman Sachs estimates that the combination of already enacted fiscal stimulus along with additionally required disaster relief legislation will raise America’s deficit to $3.6 trillion this year and $2.4 trillion next year for a total of $6.0 trillion over just these two years (Rosenberg, 2020). Given that the United States was already on track for $1 trillion annual deficit before the COVID crash, that’s a tripling of its deficits.

Who will buy all of this new debt? The Fed will.

Printing money is inflationary

The Treasury is now wiring newly created money directly into people’s bank accounts. Even if ‘helicopter drops’ of cash and the Fed’s buying of $5 trillion worth of newly issued bonds could maintain the nominal value of output and consumption, it cannot prevent the real value of consumption from declining.

Surely, you might think, we should be able to consume more than we produce during this unprecedented crisis. But how can we do so in aggregate? We are not an agrarian economy; eating our seed corn and pepper rations won’t substitute for today’s lost production. Nor will we be able to replace the lost output of goods and services by consuming imports from the rest of the world. All other countries’ output is falling too.

Real consumption must decline in line with the real value of output lost due to the cessation of productive activity. If today’s money printing does succeed in maintaining the nominal value of consumption spending, many more dollars will be chasing a smaller amount of goods and services. The result will be inflation.

Crying wolf

The boy who cried wolf is one of Aesop’s more famous fables. The moral of that story is those who repeatedly make false warnings will be disbelieved when their warnings are finally true. Are we crying wolf about an imaginary risk of inflation?

I don’t think so. I explained in 2015 why quantitative easing (QE) was not then causing inflation and needn’t cause inflation in the future. Quantitative easing creates bank reserves, which do not necessarily increase the money supply. Further, by paying interest on bank reserves, a central bank can effectively discourage banks from using those reserves to create money. I also said:

“Money printing is different from QE. Money printing is inflationary by definition. If the central bank rapidly prints a lot more currency and immediately puts it into circulation, then more money is chasing the same amount of goods and services.” 

To be clear, our worry isn’t about monetary policy conducted by the Fed. We worry about fiscal policy conducted by congress. We worry that future congresses may become addicted to imprudent deficit spending. With the economy at full employment, $1 trillion deficits didn’t cause inflation in 2019. If $4 trillion deficits don’t cause inflation in 2020 and 2021, will congress choose to raise taxes and/or reduce spending in 2022? After the economy recovers to full employment, some level of government spending in excess of tax collections will be inflationary. Inflation is ultimately a political choice.

Is this time different?

On the one hand, lessons learned from austerity in Europe following the GFC warn against failing to provide necessary emergency fiscal stimulus (Fatás, 2018). On the other hand, history also teaches us that if government sends large quantities of cash directly to people for too long, financial crisis and inflation result (Reinhart and Rogoff, 2011).

Will policy nimbly pivot to prevent inflation? The Fed can’t do it alone. Some combination of tax increases and spending cuts following the coming recovery will become necessary to prevent a spike of inflation. Will congress understand precisely when to execute this fiscal U-turn? Will our politicians display the required foresight and courage? I worry.

A future bout of high and volatile inflation may prove to be a toxic side effect of today’s experimental economic medicine. As we approach the coming recovery, investors should be on the lookout for cheaply priced inflation hedges. REITs, small-cap stocks, and commodities have become interesting, and emerging market value stocks look cheap.


Chris Brightman is Chief Investment Officer at Research Affiliates. Their long-term forecasts for over 100+ assets across global markets are available on the Asset Allocation Interactive (AAI) tool on the Research Affiliates homepage.


Gary Judd
May 05, 2020

Chris Brightman refers to his 2015 article, which gives a similar explanation of how money is created to the Bank of England article, “Money creation in the modern economy,” although I think Chris gets it round the wrong way when he says “In the normal functioning of a fractional reserve banking system …, commercial banks create money when they take deposits and make loans.”
They create the money by making the loans which are then deposits which can be drawn on.
Both Brightman articles should be read with knowledge that in the US, banks must hold reserves either as vault cash or deposits at the Fed. Both cash and reserve deposits are liabilities of the Fed and assets of the banks. When the Fed buys an asset from a bank, it pays by crediting the bank’s account with the Fed thereby increasing the bank’s reserves.
This changes the quality but not the quantity of the bank’s assets. For example, a bank may hold a government bond which the Fed purchases by crediting the bank’s reserve account. The bank no longer has the bond on its balance sheet but instead has an increase in its reserve account.
The increase in reserves allows the bank to lend more without breaching the reserve ratio which is a feature of the US banking system.
Also, the banks will have more reserves than required by the reserve ratio when they sell bonds to the Fed. If they can get a return which exceeds the return they get on their excess reserves, the banks may withdraw the excess and use it to purchase other assets, including new government bonds. Since 16 March 2020, the interest rate the Fed pays on both required reserves and excess reserves is just 0.10%.
Although Chris Brightman may be technically correct when he says that QE in the form of the Fed buying bonds from banks does not of itself increase the money supply, the purchases enable the money supply to be increased by the banks making additional loans or by withdrawing the excess and using the withdrawn money to purchase other assets.
Indeed, as I suggest below in relation to the settlement accounts of Australasian banks, the excess reserves are themselves demand deposits within the banking system and therefore represent additional money. Perhaps the correct statement is that until they are withdrawn, their impact on producers and consumers in the private economy is limited to the increase in bank lending which they enable.
Australia and New Zealand once had reserve ratios and the accompanying reserve accounts but abandoned the policy in the 1980s. The primary monetary policy tool became official cash rates on overnight loans.
The Covid 19 response includes RBA and RBNZ buying government and local government bonds which increases the price of the bonds and consequentially lowers the yields, which means lower borrowing costs in this segment of the market, including for the government when issuing new bonds to fund the increasing deficits.
The aim is also to lower the cost and to increase the quantity of bank lending to customers, and is complementary to reducing the cash rate. If bank lending increases, new money will flow into the system. It may or may not happen. It depends on the appetite of borrowers to increase their debt and banks to make loans at a time when risks are greater.
Australian and New Zealand banks do not have reserve accounts with their central banks, but they do have settlement accounts. The settlement accounts get credited when the central bank buys bonds from the banks. There is no need to keep more there than required for settlements and banks may have an incentive to withdraw the excess because the interest paid on settlement account balances is a margin below the cash rate. It may be possible to get a better return in the private market. On the other hand, especially in uncertain times a bank may wish to maintain this risk free and most liquid of assets.
Australasian central banks’ asset purchase programs will therefore directly increase the money supply because the banking system as a whole has more demand deposits (private bank deposits with the central bank, plus customer deposits with private banks). The private banks’ deposits with the central bank are immediately available to be spent by the private banks, and the demand deposits of customers are immediately available to be spent by the customers.
Withdrawals from banks’ settlement accounts must purchase other assets, including loans to customers, which increases customer deposits; they also enable the purchase of new bonds issued by the governments to finance their expanding deficits. The recipients of government bounty get cash or bank deposits which directly and immediately increases the money supply.
I should have thought that in the US, the excess reserves would have the same general effects.
Chris Brightman worries about price increases after recovery:
Will policy nimbly pivot to prevent inflation? The Fed can’t do it alone. Some combination of tax increases and spending cuts following the coming recovery will become necessary to prevent a spike of inflation. Will congress understand precisely when to execute this fiscal U-turn? Will our politicians display the required foresight and courage? I worry.
Most would share his worry.
Nor can we be certain that the inflation danger is postponed until the “coming recovery.”
Existing inventories are available to be drawn on in the short term. They will have run down during any periods of nil production and will be less easily replenished. If there are shortages, prices are likely to increase.
Already, the supply chain is affected by increased costs, and productivity is impacted by social distancing and other precautions. These are all factors which add to the likelihood of more imminent price increases, especially when government actions are stimulating demand.
If price increases are not postponed until the “coming recovery”, there is even less chance of policy nimbly pivoting to prevent price inflation.
Stagflation is the combination of recession, high unemployment, and inflation. It occurred in the 1970s and may occur again.

Peter Bull
April 23, 2020

Interesting article Chris. I was just deleting 'inflation' from my dictionary but I'm going to type it back in. Joking aside, I would add a footnote to your footnote. Too often overlooked is the inflation and deflation hedging that can be accomplished within stock selection and even individual companies. Well-timed asset allocation calls are great but they can leave a large dead hand on the other side if things don't go to plan.

April 23, 2020

One factor often omitted is the velocity of money. It has been falling thus reducing the impact of increased money supply. During the GFC we had growth in supply of goods and services. Will that continue in this COVID-19 period? Critically we rely on the Central Banks to manage this money creation and hold back the political impulse to solve every problem with more money. Its just a matter of timing as usual very hard to pick. Inflation will come as we head down this path but.... we are not there yet!


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