The coronavirus pandemic may have caught some health authorities on the back foot. In contrast, economists and economic policymakers have been quick to respond, including by summarily kicking out many old taboos. In a matter of weeks, central banks and finance ministries have adopted stimulus packages of truly unprecedented magnitude (at least in peacetime). The IMF has a good overview of measures different countries have taken.
What will be the result of this extraordinary combination of a deep supply disruption and an unrestrained effort to sustain incomes, and with them demand?
The starting point is a textbook prediction of an excess of demand and a collapse in supply: Charles Goodhart and Manoj Pradhan expect a surge in inflation. Gavyn Davies, too, warns: “If supply continues to be constrained while consumers simultaneously receive large government transfers, aggregate demand could rise in an inflationary manner.”
But is this something that should worry us?
First, note that there is nothing inflationary about the immediate injections of money by central banks into financial markets. On the contrary, the first impact of the facilities set up at lightning speed by the Federal Reserve and other central banks is not to finance greater spending but to keep financial markets functioning, which serves to sustain supply (or keep it from collapsing further as companies run out of cash). If anything, the short-term effect of that should be disinflationary.
If inflation does occur, it will instead be for one of two other reasons. In the short run, it is because a locked-down economy cannot satisfy the desired purchases of a population whose incomes have been maintained through fiscal transfers.
Indeed, in a particular theoretical sense, inflation is already rising: if everyone’s nominal income — and therefore the nominal income of the entire economy — is fully sustained but production has fallen sharply, the price of the production that still remains (a theoretical “deflator”) must be proportionately higher. Admittedly, this is not showing up in standard inflation metrics — based on actually observed prices — which, for March, are slowing rather than accelerating. That is because demand is also curtailed by people having to stay at home.
We can learn about this situation from other forms of shortage economies — wartime or the planned economies of the former communist bloc — where consumers’ nominal purchasing power could also not be met by resources that were insufficient to provide for desired consumption. In either case, inflationary pressures were suppressed by explicit rationing. In our case today, the rationing — beyond retailers’ spontaneous limits on multiple purchases of goods in high demand — is ensured by people’s physical inability to buy.
We should not be overly worried by this repressed inflation. To the extent reduced production catches up with sustained demand later on, the inflationary pressures will be eliminated — and it is precisely by sustaining nominal incomes that we stand the best chance of maintaining productive capacity through the crisis. Indeed, we should even hope that when pent-up demand is released from its effective rationing, the demand pressure encourages production above normal capacity, as business and people may be willing to put in extra effort to “make up for lost time”.
Seen in this light, if standard inflation metrics were to accelerate, we should count it as a triumph. It would mean we were not letting demand fall below the economy’s amputated supply capacity; in other words, that we were maximising the chance of a quick recovery once the crisis passes. Conversely, we should be worried if inflation is too low because it would mean we had let demand fall even further than supply.
There is, however, a second and more long-term reason for inflationary pressures. That is the large amount of money central banks will have put into circulation to help keep interest rates low as governments vastly increase their borrowing. From a mechanical point of view, one may reasonably fear that bigger quantity of money chasing a limited amount of goods and services must lead to higher inflation.
Again, however, we should not overly worry — certainly not to the extent of pulling our punches today.
We do not yet know how much bigger central bank balance sheets will be after the crisis. Some of the money being pumped in today serves to keep markets functioning and can be withdrawn quickly. If central banks convince market participants that interest rates will remain low, they may not have to use a lot of ammunition to ensure that outcome. Indeed, they may save themselves trouble in the future by explicitly targeting long-term interest rates (like the Bank of Japan does with its “yield curve control” approach). A credible commitment to buy (and sell) securities to keep long-term rates at the target could shift yields without actually doing much in the way of purchases.
Besides, central banks retain tools to slow down the circulation of money if necessary. Raising reserve requirements on banks is the most obvious step to mop up any mess from opening the monetary fire hydrants today.
All this reasoning must necessarily be highly tentative. Our economies are changing profoundly and rapidly — we still do not fully understand the impact of the global financial crisis and previous trends, let alone the enormous shock of the Covid-19 disruption. Monetary mechanisms, too, may well surprise us. But the argument above does show that for now, at least, inflationary pressures should be far down our list of potential problems.
Other readables
• In Forbes, Jason Brett has documented how, under the radar, a digital dollar was almost established in the US’s Covid-19 fiscal stimulus. A central bank digital currency available to the general public was included in draft bills in both the House and the Senate. While the final version eschewed the digital dollar in the end, it seems Senator Sherrod Brown will keep fighting for a public rival to Libra and other efforts to establish private e-currencies.
• A much-discussed study of the economic effects of social distancing during the 1918 influenza pandemic in the US is free to read online. The researchers confirm that it may be wrong to think you have to choose between public health and the economy. Their main finding: “We find that cities that intervened earlier and more aggressively do not perform worse and, if anything, grow faster after the pandemic is over.”
Numbers news
• Unanimity between economists is unheard of, but the support of macroeconomists for economic lockdowns in the face of Covid-19 is unambiguous. In Chicago Booth’s latest IGM Forum survey of the most prominent US macroeconomists, no respondent thinks lighter restrictions would help the economy, let alone the public health crisis. Emanuel Ornelas sets out what has quickly become the standard argument for why there is no “health v economics dichotomy”, but rather a subtle interplay between the optimal health and economic policy interventions which changes over time.
Source: Economy - ft.com
