Pandemics throughout history have triggered radical change, forcing societies to break with past practices. Notably, the Black Death in 1348 quickened the end of feudalism. Many think Covid-19 may herald an age of greater equality, social security and state activism. Could it also usher in the return of inflation?
On the face of it, the notion is far-fetched. Nominal 10-year US Treasury yields are close to the all-time lows plumbed in March at the height of a flight to safety touched off by the pandemic. Adjusted for inflation, yields sank below minus 1% this week, a record low, even though the federal budget deficit is likely to reach 18% of GDP this fiscal year, gross debt issuance is set to nearly double and US government debt now exceeds 100% of GDP.
The Federal Reserve’s massive bond-buying is, of course, underpinning the Treasury market. But the message from investors is clear: they are clamouring for safe assets because they are worried about the serious damage to long-term growth prospects as a result of Covid.
Yet it is that precisely the reason why some economists are worrying about inflation too. Much of Europe would have joined the US by now in double-digit unemployment but for unprecedented job- and income support schemes. With many businesses likely to close for good, governments will find it tough to wind down these programmes. And central banks will have no choice but to help their governments by continuing to buy virtually unlimited quantities of debt and keeping interest rates at record lows.
Eventually, inflation hawks conclude, prices will bubble up.
According to this line of thinking, if gold has soared to record highs it is not only because negative real bond yields make zero-yielding precious metals more attractive, it is also because some investors are anticipating that massive fiscal and monetary stimulus will eventually debauch the currency and fuel inflation.
The trade-weighted dollar, they note, is weakening steadily and inflation expectations are deteriorating: 10-year break-evens in the US – the difference between real yields on inflation-protected bonds and nominal yields – have climbed to around 1.5%.
The same fears were voiced over the stimulus unleashed in response to the 2008-09 Global Financial Crisis. They proved unfounded. The Fed, the European Central Bank and the Bank of Japan have all fallen well short of their 2% inflation target. So why might this time be different?
Russell Napier, an independent economist and co-founder of the investment research portal ERIC, had long warned about the dangers of deflation. But he recently changed his mind and now says inflation could reach 4% next year.
In Napier’s view, the only way politicians can reduce the mountains of debt they are accumulating is to make sure that inflation rates stay consistently above government bond yields for years to come.
Central banks tried to stoke inflation after the GFC and failed. What is different today, Napier says, is that governments have taken charge of the money-creation process by guaranteeing commercial bank loans to businesses affected by the pandemic.
In the US, the broad M2 measure of money supply grew 22.9% in the year to June and at a whopping 54.5% seasonally adjusted annual rate in the three months to June. In the euro area, annual M3 growth quickened to 9.2% in June.
Money creation circumventing central banks
“This is money creation in a way that is completely circumventing central banks. So I make two key calls: One, with broad money growth that high, we will get inflation,” Napier told the Swiss website The Market.
“And more importantly, the control of money supply has moved from central bankers to politicians. Politicians have different goals and incentives than central bankers. They need inflation to get rid of high debt levels. They now have the mechanism to create it, so they will create it.”
Napier says the financial repression required will be achieved through yield curve control — a policy already being followed in Japan and Australia. Specifically, he believes savings institutions such as life insurers and mutual funds will be forced to buy government debt at yields below the rate of inflation.
Brian Griffiths, who was chief policy adviser to former British prime minister Margaret Thatcher, is also worried about potential inflation. The UK’s M4 measure of money supply has been growing at a 20% rate since February, compared with closer to 4% in 2019.
The difference from the GFC is that the government is encouraging banks to lend freely – Napier’s point – and that banks are not constrained by inadequate capital. A rise in inflation, as ever, would erode people’s savings and pensions and drive many businesses into bankruptcy. With job losses looming and the disease not yet controlled, the impact would be magnified, Griffiths argues.
“Now is not therefore the time for the government to take risks with inflation. Rather, the Treasury should confirm its commitment to the 2% inflation target, publicly endorse the operational independence of the Bank of England, and produce a convincing plan to show how the deficit can be financed without excessive money creation,” he writes.
Jim O’Neill, former chief economist at Goldman Sachs, is sceptical about placing too much weight on the monetary aggregates. After all, the inaccuracy of measures of money growth and the instability of velocity of circulation – how quickly money changes hands – are why governments and central banks abandoned targeting the money supply in the 1980s.
Reported money supply “has at times been a red herring, a poor indicator not just of future inflation, but of anything in which normal people are interested”, O’Neill says.
Where does that leave us? The surge in money growth will garner increasing attention if it persists. But the world economy has changed beyond recognition since the last time money supply got out of control in the 1970s and produced stagflation.
Manufacturing is now a fiercely competitive global business, which caps price pressures. Globalisation in turn means there is a worldwide pool of labour. So unions in rich countries, which in any case are much weaker today, cannot count on inflation-busting wage increases. The inflation-pay ratchet is broken. Opec, whose oil price hikes were the proximate source of the 1970s stagflation, is now a busted flush.
Moreover, much of the increase in money growth reflects precautionary savings by businesses and households traumatised by the pandemic. With the bulk of bankruptcies and layoffs still to come, they will be wary of starting to invest and spend again. Demand will remain weak. For the next two or three years, the forces unleashed by Covid point to disinflation not inflation.