Central banks around the world have injected money
into the economy at a record pace to try to fight
a global recession triggered by the coronavirus
pandemic. Just getting word from the Federal
Reserve. Bombshell announcement from the Federal
Reserve. It is an absolutely historic week both
in the terms of the speed of Fed purchases and, of
course, the magnitude.
Since mid-March, the Federal Reserve's balance
sheet has ballooned from 4 trillion dollars to
around 7 trillion dollars, equal to about one
third of the value of the entire American
economy. A new CNBC survey showing that market
participants expecting trillions more in stimulus
from both the central bank and Congress.
At the same time, governments have enacted record
amounts of fiscal stimulus to boost economies
stalled by the pandemic.
The infusion of cash into the financial system
has renewed concerns that inflation could surge.
As Milton Friedman said, inflation is always and
everywhere a monetary phenomenon.
If you believe that, you look at the central bank
balance sheets exploding right now and you say
there's going to be inflation.
Supply shocks have driven up prices for some goods
over the past few months.
Yet recent history suggests inflation is more
likely to stay low for a long time as
unemployment remains near record high levels and
consumer spending is subdued.
While this certainly is quite a lot of disruption
to the supply side of the economy, that's likely
to be dominated by the huge hit to aggregate
demand. So how will trillions of dollars of
economic stimulus affect the outlook for
inflation?
Inflation refers to an increase in the prices of
goods or services over time.
One well-known measure of inflation in the U.S.
is called the Consumer Price Index, or CPI.
The CPI is about the prices that we pay for
services and goods and housing and rent.
Economists say some inflation is healthy for the
economy. When the economy's growing, more
consumers and businesses are out spending money
on goods and services.
This increase in demand results in higher prices.
Demand is an important factor in the outlook for
inflation. Generally, when unemployment is high
and consumer demand is weak, inflation is low.
Another factor that affects inflation is commodity
prices. If oil prices rise because there's a cut
in production, gas prices might increase too.
Consumer and business expectations about prices
are another piece of the inflation puzzle.
If a lot of people expect prices will rise in the
future, they might spend more now, ultimately
causing inflation. The level of actual inflation
that we get will be pretty heavily influenced by
the inflation rate that actors in the economies,
households, businesses, consumers, workers,
investors expect to prevail.
Like many other central banks around the world,
the Fed targets a 2 percent yearly inflation
rate. At that rate, a cup of coffee that costs 2
dollars this year would cost 2 dollars and 4
cents next year, not quite enough to break the
bank. Central banks adjust their policies
normally by changing interest rates to try to get
to that 2 percent inflation level.
You definitely want to keep enough inflation so
you can still have enough space to raise and
lower Fed funds over the business side.
Too much inflation isn't a good thing either.
As inflation rises, the money that you hold today
becomes less valuable tomorrow.
At a 15 percent inflation rate, for example, your 2
dollar cup of coffee today costs 2 dollars and 30
cents next year.
Think of how that would affect a bigger purchase
like a car. A ten thousand dollar purchase today
would cost eleven thousand five hundred dollars
next year. When the inflation rate is very
high, it is very difficult to make any calculation
about saving.
Inflation concerns for now are to the downside.
The risks are to the downside, not to the upside.
We see prices moving down.
That's because in a lot of parts of the economy,
people are cutting prices.
Lockdown's have already depressed prices in the US
as consumers stay home and remain cautious about
spending money in an uncertain economy.
The second biggest drop in headline inflation
since 1947.
Energy commodities down 20 percent, with a 20
percent decline in gasoline.
Fuel oil down 15 percent.
There have been pockets of inflation in some
areas, like groceries as more people cook at
home. Disruptions in global trade from the virus
have also raised prices for goods like medical
supplies. Still, these supply shocks haven't
offset overall weak demand.
If you're in the average person's seat, we're
talking about, you know, grocery stores and that
sort of thing. The idea that there's going to be
an outbreak of inflation, you know, 4 percent, 5
percent, that is just not on the horizon.
Many economists and policymakers expect wages will
stay low as unemployment remains high.
Meanwhile, people are saving instead of spending
their cash out of fear the economy could get
worse. To try to
boost the economy, policymakers in Washington
have pumped trillions of dollars into the
financial system in recent months.
Economic theory suggests all this money printing
could create the risk of inflation.
Economist Milton Friedman famously said that if
there's too much money in the economy, chasing
too few goods prices will rise.
When inflation was surging in the 1980s, Fed
Chairman Paul Volcker put Friedman's theory to
the test, and it worked.
Volcker slowed the growth of money going into the
economy and raised interest rates to tame
inflation. But economists say there's been a
break in the link between money creation and
inflation in recent years as the banking system
has become more complex.
The rise of the financial system and the sort of
the diversification of the financial system is
one of the reasons why sort of the Milton
Friedman view of the world really is not as
applicable, particularly in the United States, as
it was in an earlier time.
It's important to understand that when the central
bank prints money today, most of it isn't in the
form of physical dollar bills.
Instead, the Fed creates electronic money.
It uses that electronic cash to buy assets and
lend to banks, injecting money into the banking
system. To buy treasuries, for example, the Fed
uses so-called primary dealers, a group of around
two dozen big banks and brokerage firms that
trade bonds. What happens when the Fed creates
money? It strictly creates central bank reserves.
Those are held by the banking system.
The banks decide, you know what what they're
willing to lend out into the economy.
That means that even if the Fed is pumping a lot
of money into banks like it is today, the money
won't reach the hands of consumers until banks
lend it out. It is true that money has been
handed out directly to citizens as part of the
federal government's coronavirus response, like
the 1,200 dollar stimulus checks.
This cash infusion still may not result in
inflation. Most Americans needed the checks to
make day to day payments to make up for lost
income during the crisis.
Not to go out and spend lavishly on other
purchases. I think of them as more life
preservers, trying to prevent the economy from
getting into a deeper hole because of the Kovik
crisis. And they don't represent stimulus yet.
Recent history suggests that all the fiscal and
monetary stimulus daring the pandemic is unlikely
to increase prices for consumers when the Fed
bought trillions of dollars of assets after the
2008 financial crisis, inflation never surged.
After the Great Recession, there was a conviction
that all the fiscal and monetary stimuli were
going to result in huge inflation.
As a matter of fact, a number investors,
including some very famous hedge funds, went to
gold. Well what happened?
Big deficits, but inflation has come down.
The experience of the last decade is that central
bank balance sheet expansion certainly need not
generate a period of excess inflation.
And in fact, even with a big balance sheet to be
hard to get the inflation that you want.
There are limits to what history can teach us when
it comes to understanding the economic situation
right now. Even if the economic stimulus doesn't
result in higher prices for consumers, many say
that inflation is showing up in the prices of
other assets like the stock market or the housing
market. One of the most interesting questions
that we have right now is the difference between
the price inflation that you and I see at the
grocery store or at the gas pump or when we're
buying something.
That's one measure of inflation.
But another measure of inflation that is also
very important is asset price inflation.
In other words, what's happening to the stock
market and what's happening to credit spreads?
I think we're looking at a very significant
increases in asset price inflation.
Inflation expectations are another risk.
People start thinking all of the money supply is
increasing. Inflation is going to be higher.
Then expected inflation becomes high.
Then you start asking for increases in wages and
prices. And these expectations become what we
call self-fulfilling.
In the long term, factors like globalization,
technology and aging populations all play a role
in consumer prices.
A weaker U.S. dollar or a backlash against global
supply chains, which have been disrupted during
the pandemic, could create inflation risks.
If you were to seal the borders and literally cut
off any imports and then embark on this huge
monetary and fiscal stimuli, yeah, they could
they could create inflation.
There's one more big risk to inflation, and it
comes with nine zeros attached.
Record high public debt.
Trillions of dollars in economic stimulus during
the pandemic have increased government debt at a
rapid pace.
In recent years, some economists have argued in
favor of deficit spending to fund public
investment. Though many debate what effect this
could have on inflation.
Because government debts are set in fixed dollar
amounts, higher inflation makes it easier to pay
off those debts.
Some worry that politicians might put pressure on
central banks to chase higher inflation to help
finance the growing national debt.
We need not worry too much about the size of the
Fed's balance sheet.
What we need to be focused on is whether the Fed
will at the appropriate moment have both the
judgment and the institutional independence to
raise interest rates, even if that might conflict
with some other interests, for instance, the
interest of the government of today.