We constantly hear reports of a pent-up demand/ wave of money to be spent as the economy here and internationally opens up post pandemic. This will be following a period of unprecedented government supports where money was pumped into the economy to keep it afloat when it was put into shutdown. The PUP scheme in Ireland, the Furlough scheme in the UK are all examples of this. These government supports ultimately become government debt which has to be paid for with higher tax revenues in the years ahead. The deficit for the Irish government in 2020 was €19 billion, for context in 2019 we had a budget surplus of €1.9 billion. We have been fortunate to be able to borrow at historically low interest rates. One way to ease this debt burden over the medium to long term is through inflation. This pent-up demand/ wave of money will potentially lead to price increases in the economy through what is known as inflation.
The debate of the year so far in financial markets has focused on whether the extraordinary and growing policy stimulus applied in the wake of the COVID-19 pandemic is likely to generate an inflation breakout that policymakers will find difficult to restrain. There is a goldilocks type scenario here where we need inflation but too little inflation (or deflation) or too much inflation can be a problem.
The two camps
In one corner are economists like former US Treasury Larry Summers, who are worried that President Biden’s $1.9 trillion fiscal stimulus package, alongside other fiscal and monetary measures, may turn out to be too much of a good thing.
“I am concerned that progressives have a tendency to overreach,” Summers said in an interview with Bloomberg Television. “You need to be progressive but you also need to get the arithmetic right, and I am worried that this program could overheat the economy.”
In the other corner, are names such as economics Nobel laureate Paul Krugman, who argue that any spike in prices is likely to be transitory and that this period is unlike the 1970s when inflation became embedded in the economy and took a deep recession to purge.
For their part, central banks themselves lean more toward Krugman’s view. In maintaining super easy monetary policy, the US Federal Reserve has argued that any expected increase in prices this year is likely to fade on its own, with the path of the virus still the key determinant for policy.
What are the markets saying?
The bond market, after a shaky start to the year, appears to have accepted that message. Yields stabilised amid evidence that inflation is still stuck well below central bank targets and unlikely to move upward soon in a global economy with plenty of excess capacity.
Commodity markets, however, have been pointing to a steadily reflating world economy. The prices of many raw materials, from iron ore to copper and to corn, have been climbing in recent months as global economic activity ratchets up.
“Nearly all commodity prices rose in the first quarter of the year and most are now above pre-pandemic levels,” World Bank economists said in a recent paper.
The question is whether this rally in commodities presages an outbreak of inflation, which the textbooks define as a general rise in the level of prices of an economy over a period of time.
'Slack' in the economy
It’s this last point which Professor Mark Blyth, a Scottish-born political economist with Brown University in the US, says is worth recalling. While prices may spike in certain industries and sectors in the coming months, that does not necessarily spell inflation.
“No central bank that’s got a brass nameplate worth a damn has managed to hit its inflation target of two percent in over a decade,” Blyth said in a recent podcast. “All that would imply that there is a huge amount of what we call ‘slack’ in the economy.”
Blyth argues that the economy is fundamentally different than in the stagflation era of the 1970s. Globalisation, the removal of tariffs, the destruction of trade unions, the carving up of cartels and the introduction of hundreds of millions of people into the global economy has destroyed the pricing power of companies in developed economies.
This doesn’t mean there won’t be price increases in the next 12-18 months, partly due to supply chain problems and the running down of inventories during the pandemic. But Blyth argues that talk of a 1970s-style inflation spike is fanciful.
”For Larry (Summers) to be right what would have to be true? That we would have to have the institutions, agreements, labour markets and product markets of the 1970s. We don’t. So, I just don’t actually see what the generator of inflation would be.”
Time will tell who is right, but in the meantime it seems central banks and governments are willing to roll the dice and gamble that the greater risk in the near future is not a breakout of inflation but a faltering of the nascent economic recovery.