Exploring inflation risks

In the December commentary Forbes Elworthy asks “How do we get the money printing genie back in the bottle?”.

A. Overview

Nobody can predict future paths of economies with certainty. “Events, dear boy”¹ will perturb future outcomes in unknowable ways. Nonetheless, this Commentary will explore the risk of future inflation, despite the seemingly low probability of it occurring in the next year or two.

Most current economic and financial commentators and models assume low inflation and low interest rates for long into the future.² It has been low in most economies for most of the past 20 or 30 years. However, if inflation does arise, it would be a radical change for a world where cheap labour and cheap money have become almost constants.

If we experience inflation it will be because labour and other inputs have become more expensive (for demand pull or supply push reasons or because trust in currencies is lost). This would be followed by more expensive capital (with lower prices of financial assets), in part because the real value of what are currently “excess savings” would have been reduced. Scarcer capital would demand higher discount rates of expected cash flows.

Historically, once governments become addicted to printing money to address crises, inflation begins to have a non-trivial chance of recurring.

1. Harold Macmillan is said to have replied “Events, dear boy” when asked what was most likely to knock governments off course.

2. Humans are bad (“disaster myopic”) at acting to address complex but potentially disastrous future outcomes. When faced with “remote” events such as climate change or the spread of viruses, we often understate their risks. We are inclined to assume the realities with which we are familiar will continue. See New Yorker article Before the Fall: Disaster Myopia at the Fed.

B. Possible financial impacts of inflation

When inflation increases, financial markets quickly understand a dollar tomorrow is likely to be less valuable than a dollar today. That said, there will be lags in those markets dominated by government intervention. As we will explore in Section K below, interest rates that are controlled by central banks such as the Federal Reserve may not rise for some time even in an inflationary context. However, private sector-controlled discount rates would certainly rise.

Such changes could be dramatic. As Gavin Davies observed in the FT on 13 December 2020 in the first three years of the inflation shock of the 1970s average investors lost 10% a year in real terms. This was a 30% reduction in their wealth.

C. What do my readers think about the politics of sound money?

None of the 25 readers who kindly responded to my “No Constituency for Sound Money” Commentary disagreed with its central point that no meaningful constituency, on either the left or the right of the political spectrum in any major country, is currently arguing that maintenance of a constant supply of money by the government is more important than the alternative we have chosen. That alternative is printing large amounts of money to help individuals and businesses stave off the income losses that would otherwise have resulted from the coronavirus restrictions.

D. How much money is being printed?

Economies such as China and NZ that managed to control Covid (highlighted in yellow in table) still needed government support (both fiscal spending and loan advances) of approximately 20% of GDP in 2020.

US Government Deficit

3. and 4. IMF Fiscal Monitor; Policies for the Recovery; October 2020
5. Ceyhun Elgin, Centre for Economic Policy Research COVID Economics Issue 3

Meanwhile countries that failed to control Covid, such as the US, UK and Germany, engaged “spending + lending” of closer to 30% of GDP in excess of taxation in 2020 (grey highlights above).

E. Are these levels of unfunded government spending high?

These are unprecedented levels of non-tax financed government spending (US deficit shown below).

Rising Spending – Not Falling Revenues – Drives the Long-Term US Gov Deficit

Source: This article from the Manhattan Institute using CBO 2020 Long Term Budget Outlook

F. How is the base money supply evolving?

US M1 (the supply of base US$) has grown rapidly in 2020 (below).

M1 Money Stock

Source: FRED

Where is all of this money going? While some is being absorbed by retail banks as increased capital reserves, in the 8 months to October 2020 total US demand deposits at banks increased by 53% and those in NZ increased by 35% (below) . These are rapid changes in the liquidity of savers compared to the preceding 10 years, during which bank deposits grew by approx. 5% p.a. See below bank deposits over the past four years in US and New Zealand.

United States Bank Call Deposits – $bn

Source: FRED, Federal Reserve of St Louis

NZ Aggregate Bank Call Deposits – $m

Source: RBNZ

G. My readers’ views on inflation

Few of my correspondents share my concerns about inflation. Most expect that actors will save rather than spend the new money created in 2020 and 2021. They point out that individuals and businesses who gained from the rounds of Quantitative Easing after 2009, did not rush off and spend the money. On the contrary, the past 10 years was a period of near deflation. The Japanese, also, saved rather than spent the money created by the deficit spending of the past 25 years.

A minority (five) of my readers, however, do worry about inflation. Some expect more “demand pull” or “quantity theory” inflation as more currency in circulation chases the same amount of goods and services. Or “supply push” inflation, as fewer or more expensive inputs create bottlenecks (e.g. less availability of cheap labour as globalised supply chains and immigration are curtailed). Two of my respondents are concerned about a diminution of trust in currencies. One imagines economies as a formerly “fair” lottery that then begins to pay all participants large annual sums e.g., $20,000 for each citizen. He asks, “might these actors begin to look more closely at the value of a prize that everyone wins”?

H. Why did price levels not increase during the post 2010 quantitative easing?

Why were inflation hawks (such as me) proved wrong when the amount of money available increased under Quantitative Easing, but prices did not rise? The main reason, in my view, is we can now see that owners of investments were not made better off by QE. If a bond or a commercial building doubles in value but its $ yield remains the same (falls from 6% to 3%) is the owner of the building any better off? To protect their spending power investors in the age of QE have been rational and held rather than spent the asset price gains they accrued from QE.

I. What do experts think will happen?

Last month I quoted Paul de Grauwe the Professor of Political Economy at the London School of Economics who predicts inflation of 4-6% per year in the Eurozone from 2021 to 2025. He argues that Monetary Finance is different from QE in that it will find its way into the hands of the broader population, who have a higher propensity to consume than asset owners. De Grauwe is probably in a minority of economists in his predictions. However, as we will see in Section K, the Governor of the US Federal Reserve also recently (in his August 2020 Jackson Hole speech) argued that US monetary policy needs to directly support employment and achieve annual inflation “above 2%”.

J. What is happening in New Zealand?

I recently spent six weeks visiting New Zealand which came out of national lockdown in May-June 2020 and is now experiencing rapid economic growth and tight labour markets – despite the closure of inbound tourism. GDP fell 12.2% initially in the second quarter of 2020 before rising 14% in the third. NZ GDP is expected to be down 3% for 2020 compared to an approximately 10% fall in GDP in the UK. Based on levels of economic activity I witnessed while there, I expect ebullient economic conditions, accompanied by some inflation, in New Zealand in 2021 and 2022. E.g., Craigmore will give pay rises of 20% (from $18 per hour to $22 per hour) to our orchard workers this year – to attract labour in a tight labour market. Separately Craigmore (partly to be as attractive as possible to scarce labour) is planning to build worker accommodation for 100 to 150 staff. Construction labour is tight in NZ right now and so we expect to have to pay handsomely for labour, as well as imported international inputs (e.g. steel) now being shipped to NZ on less efficient international logistics chains.

Perhaps three months after vaccines become widespread, so hopefully from mid-late 2021, European, US and other economies may also roar back to life. Newspaper stories, then, are likely to talk about tight labour markets in construction and food service and agriculture. As the newspapers are already reporting in New Zealand.

K. Don’t fight the Fed

In August 2020 the US Federal Reserve announced it would now shift to targeting inflation “moderately above 2 percent for some time”. At the same time, the world’s leading monetary authority revised its objectives to place full employment rather than avoidance of inflation as its central policy goal. This shift takes Federal Reserve policies back to the Keynesianism of the 1960s, where accommodative policies were initially successful in supporting economic growth and full employment. However, when faced with the large fiscal deficits and the economic shocks of the 1970s those policies failed amidst the stagflation of the 1970s.

It seems the Fed now regrets its attempts to raise interest rates and curtail money supply in 2016 to 2018. They are unlikely, now, to try to pre-emptively raise rates even as the economy recovers. Since other central banks are likely to behave similarly investors can now expect that even as economies recover and prices and wages begin to rise, governments are now likely to allow negative real interest rates to continue well into the future.

L. A Return of the Roaring Twenties

As we were finalising this Commentary Dr Nicholas Christakis a Yale social epidemiologist specialising in behaviour patterns forecast a return to a raunchy, Roaring ‘20s – “by 2024”. He observes that human societies have experienced epidemics many times before, which invariably lead to high savings rates and “religiosity”. We have seen that above in rapidly increasing bank deposits in the US and NZ. However, once the epidemic is addressed by modern medicine, he expects a resurgence of spending, ‘sexual licentiousness’ and a ‘reverse of religiosity’. The ebullience of the Roaring 1920s was, in part, a recovery from the 50 million global deaths of the 1918/19 Spanish flu.

Christakis’ prediction matches that of de Grauwe. That the savings of the Covid-19 period are likely to be spent more vigorously than those salted away by the beneficiaries of QE, since this “wealth” has found its way into the mainstream population, not just the hands of the already wealthy.

This increase in consumer spending, if it occurs, may cause an increase in aggregate demand for both consumer goods and economic resources (i.e., what will feel like a boom), and therefore potentially cause price inflation.

M. Conclusion: it will be hard to put the money printing genie back in the bottle

Early in World War One Germany decided that it would not raise taxes to pay for its war effort but instead would issue bonds (some of them to government banks that printed the money to buy the bonds) to pay for the war effort.⁶ In other words, to “monetary finance” its activities. Initially this policy was successful in supporting the war effort while not raising taxes. And the policy was accepted by the population as being needed to deal with crises. Each year felt uniquely bad. The next year would be better⁷ and the unorthodox policies would then no longer be needed.

It took nine years of rolling crises from the commencement of Germany’s monetary innovation until the currency collapse in the face of France’s annexation of the Ruhr. Few in Germany in 1914 to 1923 believed that “Sound Money” was feasible, or even prudent, in the face of their various challenges. Instead, they opted for deficit spending and money printing to pay for, first, the war and then the crises after the war. Each decision, on its own, made sense in the short term. However, cumulatively, and in retrospect, we can see Germany had become addicted to the printing press to keep each government of the day in power. A policy that turned out to have dire consequences.

Germany was then constrained in ways unlike any modern economy. I am not predicting any major currency will collapse in the same manner. However, the monetary policies of this period, like the Keynesian policies of the 1960’s, resemble our own evolving policy environment in that we cannot see an alternative to printing, each year, as much as 20% to 30% of GDP. If we continue to do this in the face of future crises (or political requirements, whether from the left or from the right) then, just as happened in Weimar Germany and in the 1970s, is there not a risk that the sheer quantity of money being created will eventually create problems in itself? Either credit crises and/or inflation?

In summary many previous societies, like ours, have resorted to the printing press, and ever larger amounts of debt to support policy objectives, while minimising taxes. In the short and medium term, these policies can be effective. However, in the longer term, equilibria become unstable. Societies then face a choice. Those keen about “sound money” (as the US was in 1929 to 1933) will likely allow widespread defaults and falls in asset prices to rebalance monetary markets. Other societies will pursue a more humane and, in the short term, more attractive path of money printing and thereby government support for the economy. For a time, this will be successful as credit and confidence themselves contribute to GDP and their absence shrinks GDP.

However, such experiments seldom survive forever. As societies who use successively more rounds of money printing eventually discover, the returns on money creation eventually diminish, either in the face of defaults and disequilibria, or in the face of inflation.

In the second two thirds of 2020s (just has happened in the major economies after WW2) there are reasons to expect a modest inflation, of perhaps 4% to 5% per annum.

In this circumstance laggard sectors of the past 10 or 20 years may “catch up” as the sources of income and wealth in the economy rotate. Workers’ wages would rise by at least annual inflation. Farmers and other suppliers of commodities and other resources should also find their income revalued upward.

Conversely such inflation would not be kind to many financial investments, whose prices may be expected to fall, at least in real terms.

6. Adam Ferguson, “When Money Dies, The Nightmare of the Weimar Hyper-Inflation” 1975, pg. 10
7. Adam Ferguson, “When Money Dies, The Nightmare of the Weimar Hyper-Inflation” 1975, pg. 3

Once again – your replies and comments on these ideas would be most welcome.

Wishing all our Craigmore Commentary readers a very Happy New Year,

Forbes Elworthy