We are currently undertaking an amazing live experiment to see if the traditional belief that highly expansionary fiscal and monetary policies will eventually lead to a revival of high inflation, leading to higher interest rates and then a recession, still holds true today.
In the decade since the financial crisis, advanced economies were more likely to struggle with inflation being too low rather than the opposite as evidenced by the ongoing failure of the Fed, the ECB and Bank of England to lift their policy rates significantly over that period. Likewise, many would agree that a small amount of inflation would have been a price worth paying to prevent the pandemic induced recession turning into a 1930s style recession. We’ve avoided this (so far) but the expansionary fiscal and monetary policies are being continued more aggressively than most economists would have expected, especially in the US where the $2 trillion Covid stimulus is now followed up with plans for a $3 trillion infrastructure plan.
Cebr is forecasting a rise in inflation in the UK to 3% by late 2023 though the price level is expected to come down again in the following years with only modest interest rate rises. In the very near term, there are some clear indications of rising inflationary pressures in the UK such as a near two-year high for producer prices recorded in March, rising commodity prices and widespread supply shortages for goods such as computer chips. Unusual weather events and one-off factors such as the blocked Suez Canal are further adding to supply lead times and prices. The opening of the economy over the spring and summer will likely lead to further price increases in the services sector as consumers splash out on entertainment and hospitality leading to a short period of higher inflation this year. It is also worth noting that some of the evidence of inflation may not be picked up in official data. Coca cola in its price rise announcement made clear that sizes of cans would be adjusted to maintain price points. Many restaurants reopening have new menus that make price comparisons very hard.
The more interesting question is, however, what will happen to inflation once the more transitory of the above mentioned effects subside. The inflationary risks for a country like the UK are from three sources: domestically generated inflation, inflation rising on the back of a depreciating currency or the national price level reacting to the international economic environment. On the whole the chances of serious domestically generated inflation are low unless the international environment is also inflationary. And the Bank of England’s Monetary Policy Committee is likely to work hard to prevent a serious collapse in sterling. But the international environment is different.
Essentially what happens around the world for fiscal and monetary policy is driven by the US, which, because it the issuer of the world’s de-facto reserve currency, has a lot more flexibility to determine its own policy than any other country. And here the story gets interesting. Monetarists argue that monetary growth on the scale that we’re currently observing, especially in the US, will automatically lead to inflation. In the US, M2 was up 27.1% year-on-year in February with the equivalent figure for the UK standing at 14.4%. Hard-line monetarists like Tim Congdon expect the US to suffer double digit inflation as a result. Hard-line Keynesians like Paul Krugman see a short term spike as we recover from the pandemic but no endemic inflationary problem. But there are still quite a few sceptics including illustrious names such as Larry Summers and Oliver Blanchard, who argue that the Biden administration’s spending plans will need to be monetised and will fuel inflation. Whether US government spending will prove inflationary or not depends on a number of factors, including whether households spend most their Covid stimulus or rather use it to repair their balance sheets, how quickly the labour market recovers and we see wage pressures emerging and – in the case of the US infrastructure plan – if the US public sector manages to get a grip on the costs in sectors such as health care and construction.
It is theoretically possible for the UK to follow a non-inflationary path even if the US does not. In the 1970s Switzerland and Germany largely avoided the worst inflationary excesses. But to do that would mean letting the pound rise, possibly sharply. We would be surprised if this were allowed to happen at a time when exports will be coping with the aftereffects of Brexit.
If not, and the US outlook turns out to be inflationary, we risk importing their inflationary pressures and then creating a boom-and-bust cycle in the 2020s.
We don’t pretend certainty in this field. Amongst the key issues at stake are whether the information economy, with its ability to expand supply at low marginal cost, changes the rules. And in the UK have the Thatcherite labour market reforms made it less likely that a wage price spiral will develop. What seems clear is that a once-in-a-century pandemic is followed by a similarly monumental experiment in economic policy.
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