The return of inflation? Lessons from history and analysis of Covid-19 crisis policy responses.
The IIMR Annual Money Conference took place on Wednesday the 28th of October 2020. The full programme for the conference is available here.
A brief note on each of the sessions by the Chairs and the speakers. The videos with
the conference presentations will be available on the IIMR’s YouTube channel.
Session 1 – What explains inflation?
Chairperson: Peter Bofinger
In their paper on “‘Effects of the changing trends in demography and globalisation on inflation” ’C. Goodhart and M. Pradhan argued that the rise of China and demography created a 'sweet spot' that has dictated the path of inflation, interest rates and inequality over the last three decades. But as that sweet spot turns sour, the multidecade trends that demography brought about are set for a dramatic reversal in the inflation trend.
In their paper “Do Enlarged Fiscal Deficits cause Inflation? The Historical Record”, Michael D. Bordo and Mickey Levy presented the following key lessons: “Avoid war, be cautious of sustained monetary accommodation of fiscal deficits, avoid fiscal dominance, maintain central bank independence, keep inflationary expectations anchored, (…). Above all, ignoring the lessons from history could be at the policy makers peril.”
Charles Goodhart and Manoj Pradhan: Effects of the changing needs in demography and globalisation on inflation.
Globalisation, especially the stunning rise of China, and demography have been powerful disinflationary forces over recent decades. But their current reversal will lead to a return of inflation, higher nominal interest rates, lessening inequality and higher productivity, but worsening fiscal problems, as medical, care and pension expenditures increase in our ageing society. Meanwhile, debt has been massively accumulated, driven much further by the pandemic, making control of inflation much harder in future. Be warned, the future will not be at all like the past.
Michael Bordo and Mickey Levy: Do enlarged government deficits cause inflation?
The state of nature, war or peace is a key determinant of the connection between fiscal deficits and inflation. In major wars fiscal deficits are often financed by central banks absorbing government debt at a low interest rate peg and raising inflation tax revenue.
In peacetime fiscal deficits can be accommodated by expansionary monetary policy leading to high inflation. Two factors are salient: political dysfunction as in France in the 1920s or flawed doctrine as in the US and UK in the Great Inflation of the 1960s
The present pandemic emergency may combine elements of both the peacetime and wartime experience.
Session 2 – Will Covid-19 crisis be inflationary or deflationary?
Chairperson: James Ferguson
‘On the monetary response to a supply-side crisis. Recovery and inflation scenarios in the USA for 2021’. By Lars Christensen.
Christensen is a market monetarist so, whilst he acknowledges Fisher’s M*V = P*Y
equation, when determining inflation P = (M*V)/Y he emphasises what he calls the
dynamics of money demand, which he argues depends crucially on the credibility of
the policy regime. In other words, Christensen believes that the market, specifically
the inflation forecasts implicit in bond yields, is telling us that the velocity of M2, which has been "trending down for 20 years", will not revert to trend. Because M2 is driven by deposits and deposit growth is "now zero”, inflation expectations remain sub-2%.
Some criticisms however, do spring to mind. First, the use of a broader measure of
money (e.g. M3, or even better, the broad money aggregate derived from the quarterly flow of funds data) reveals that for 60 years velocity, whilst declining does so at a (usually) stable rate of around 0.6%; therefore sharp declines in velocity, as seen in the Global Financial Crisis and in the Covid Crisis, tend to return to trend (observable after the GFC but remains to be seen in the latter instance). If velocity is trendreverting, then as savings deposits get used to fund either consumption or investment, there will be upward pressure on prices and bond yields will move to reflect that, nullifying the market-signalling non-inflationary argument.
Second, the growth rate of deposits is not “now zero.” Even if we restrict ourselves to
M2, growth over the 3 months to end-Sept alone was +2.7%, an annualised rate of
almost 11%, the strongest growth rate since 1984.
Third, the policy prescription to use the “money base growth as the primary (only)
policy instrument” is wholly misleading during times when bank lending might be impaired and would, indeed arguably did, have catastrophic consequences during the early years of the GFC; when monetary base growth looked highly inflationary but M3 broad money was barely growing at all.
‘The money-to-equities channel, or why monetary policy can never be exhausted’. By
Tim Congdon and Juan Castañeda
Congdon and Castaneda argue that monetary policy can never be exhausted because, as QE has shown, the central bank can always add to non-bank deposits. It might not even matter much if velocity collapsed and stayed low because there is another, overlooked, inflationary channel running from money growth to equities.
Long-term savings institutions, whose assets in the US are roughly equivalent to both GDP and broad money supply, have never allowed their cash balances to move outside of 4-5.5% of total net assets for the last 20 years and it would be outside their remit to start now.
Furthermore, the authors argue that relatively small changes in money directed towards long-term savings institutions can have an outsize impact on equity prices such that, in their merely illustrative theoretical example, a 15% increase in money supply leads to a 50% increase in the equilibrium value of equities.
The 24% increase in M2 since end-Feb remains mostly in bank deposits for now but
the portion that is not permanently held for precautionary reasons or used to fund
consumption will be invested and, as Congdon and Castaneda note, fluctuations in
the growth rate of money held by the financial sector have greater amplitude than
fluctuations in broad money. It would have been nice therefore to see their theory
tested empirically, to show how fluctuations in financial sector money holdings have
interacted with equity prices in the past.
Tim Congdon and Juan Castaneda: The money-to-equities channel, or why monetary policy can never be exhausted.
An abstract of ‘Can central banks run out of ammunition?: the role of the moneyequities-interaction channel in monetary policy’ – presentation/paper (A joint presentation based on the paper to be published in Economic Affairs, 2021, written by Tim Congdon) given at the Institute of International Monetary Research conference on 28th October, 2020 by Juan Castaneda and Tim Congdon.
Many authorities claim that “central banks have run out of ammo”, either because the central bank has dropped to close to zero and cannot go lower (“the zero lower bound”) or because of Keynes’ liquidity trap. The liquidity trap is a separate pathology in which increases in the quantity of money cannot raise bond prices and reduce bond yields.
The paper argues, first, that indefinitely large increases in the quantity of money remain possible even when the central bank rate is close to zero, and, second, that increases in the quantity of money boost all asset prices, including the prices of quoted equities, and not just the price of bonds. Bonds are an unimportant asset class in modern capitalist economies, relative to corporate equity and real estate. Meanwhile increases in equity prices (via “the money-equities-interaction channel” which works most simply in the institutional fund management industry) always promote aggregate demand and output.
Session 3 – Inflation episodes and central bank policies in historical perspective
Chairperson: Chris Neely
Session 3 focused on the historical experience determinants of inflation, starting with the near history discussed by Bob Hetzel. Hetzel notes that the Fed has replaced its previous Volker-Greenspan policy of pre-emptive action on inflation with a policy that seeks to aggressively reduce unemployment with the flatness of the current Phillips curve and promises of making up for downside inflation errors. Hetzel sees this as risking a return of uncontrolled inflation. George Selgin goes back further, comparing current Fed policy to that of the Fed in the 1930s. The author sees substantial differences in fiscal policy and even larger differences in monetary policy between the eras, with the Fed fulfilling Bernanke’s promise to avoid a repetition of the 1930s. Finally, Capie and Wood review the usual conditions necessary for debt sustainability and some historic experiences with debt and inflation. The usual rule-ofthumb is that growth must exceed the real rate of interest for debt to be sustainable. But the authors point out that the real rate of interest depends on the trust of the public that the government will not inflate away the debt.
Robert Hetzel – The US Fed response to Covid-19 crisis as compared to the Global Financial Crisis
To understand both how it controls inflation and how it trades off inflation with its goal of maximum employment, the Federal Reserve System uses a Keynesian framework in which monetary policy moves the unemployment rate relative to a presumed full employment value, termed the NAIRU. Because it does not know the value of NAIRU, its policy is to pursue an expansionary monetary policy until inflation rises. This policy risks reviving the inflationary monetary policy of the 1970s.
George Selgin – The fiscal and monetary response to Covid-19. What the Great
Depression has – and hasn’t – taught us.
(1) Although some regard the New Deal of the 1930s as exemplifying an aggressive
fiscal and monetary response to a severe economic crisis, the U.S. fiscal and
monetary policy responses to the CORONA-19 crisis have actually been far more
substantial--and, this far at least, far more effective in reviving aggregate spending.
(2) Although many fear that these responses, and the large scale increase in bank
reserves especially, must eventually cause unwanted inflation, the concurrent, sharp
decline in money's velocity has thus far more than offset any inflationary effects of
money growth, while forward bond prices reflect a general belief that inflation will
remain below 2% for at least another decade. Notwithstanding the growth of the Fed's balance sheet, Fed authorities can always check inflation by sufficiently raising the interest return on bank reserves. It remains true nonetheless that recent developments have heightened the risk of "fiscal dominance" of monetary policy at some point in the future.
Forrest Capie and Geoffrey Wood – Debts, deficits, central banks and inflation.
What insights can history provide for central banks hit by large rises in government
1. Debt to national income ratios have soared, the result of government response to
the latest corona virus. These need not be reduced over a short time horizon provided subsequent expenditure is restrained. British experience since the early 19th century shows that. Nor need there be inflation.
2. But to achieve this trust in honest and competent government to pursue long term policies is essential.
The papers presented by T. Congdon, G. Selgin, F. Capie and G. Wood, R. Hetzel and M. Bordo and M. Levy will be published in Economic Affairs in 2021
‘Effects of the changing trends in demography and globalisation on inflation’ M Pradhan, C Goodhart
'Do enlarged government deficits cause inflation?' M Bordo
‘Recovery and inflation scenarios in the USA for 2021’ L. Christensen
‘The money-to-equities channel or why monetary policy can never be exhausted’ by Tim Congdon and Juan Castaneda
'The US Fed response to Covid-19 crisis as compared to the Global Financial Crisis' by Robert Hetzel
‘The Fiscal and monetary response to Covid-19: what the Great Depression has (and hasn't) taught us’ by George Selgin
‘Debts, deficits, central banks and inflation. A historical perspective’. By Forrest Capie and Geoffrey Wood