Many people have already written about how the ‘spectre of inflation’ has returned to haunt global investors. In reality, financial markets are still surprisingly relaxed about the risks, and most measures of inflation expectations have risen only slightly. This seems increasingly complacent.
In part this reflects the persistently dovish messages from the world’s major central banks. The Bank of England’s latest Monetary Policy Report is just one more example.
The good news is that the Bank has bumped up its forecast for UK GDP growth in 2021, from 5% to 7¼%, and revised down its forecast for the peak in unemployment, to just under 5½%. (As it happens these are the sort of numbers I’ve been pushing since January, proving once again that even a stopped clock is right occasionally.)
But despite this, the Bank only expects consumer price inflation to rise to 2½% later this year, before falling back neatly to its 2% target. What’s more, the risks to these projection are judged to be ‘broadly balanced’.
That judgement is hard to understand when practically every inflation indicator is pointing to significant upside risks. In particular, the price components of many business surveys (notably the PMIs compiled by Markit) are already consistent with inflation rising to 3% to 4% in the UK – and 5% in the US).
For now, central banks seem willing to downplay this evidence. The accepted wisdom is that most of the upward pressure is due to factors which should prove temporary, including the rebound in oil prices and Covid-related disruption to global supply chains. In the meantime, a lot is made of the fact that inflation expectations remain ‘well-anchored’.
There is also a good case for arguing that a little extra inflation may not be a ‘bad thing’. The US Fed has explicitly said it will tolerate a period of inflation above its long-term target of 2% after a period when actual inflation has been running persistently below this goal. Other central banks can be forgiven for thinking the same way.
Indeed, whether the return of inflation is a serious problem clearly depends on how high it rises, for how long – and why. UK inflation of 3% for a year or two, driven by strong economic growth, would be a pretty benign scenario. Interest rates might be a little higher than they are now, but still low enough for the debt burden to fall.
The problem, of course, is that once inflation does accelerate it is hard to bring it back under control again, especially if expectations of higher inflation become the norm.
Above all, as any student of economics should know, inflation is caused by too much money chasing too few goods and services. Global money growth has exploded, largely as a result of the way in which central banks have embraced quantitative easing (QE).
Unlike the period after the global financial crisis, the latest bout of QE is being accompanied by looser fiscal policy, and the banking system itself is still working well. This means that more of the additional money is readily available for businesses and consumers to spend, when they are able and willing to do so.
In the UK, ‘broad money’ is still expanding at an annualised rate of nearly 10%. This measure is a good leading indicator of nominal GDP, suggesting that we are heading either for a period of very rapid growth in economic activity or much higher inflation – and possibly both.
Nonetheless, there was not a single reference to the money supply (or anything related) in the Bank’s latest Monetary Policy Report. Even if you are not a diehard monetarist, that seems an extraordinary omission.
The upshot is that the risks to inflation are surely skewed in one direction, given the prospect of a surge in pent-up demand fuelled by money printing. Unfortunately, politicians worldwide still seem hooked on providing even more stimulus.
The US provides a warning here, rather than a model to follow. The Biden administration has rushed through an additional $1.9 trillion spending package (the ‘American Rescue Plan’), but it is far from obvious that the US economy actually needs this. Indeed, US inflation is already taking off.
The Bank of England has at least confirmed that it will now slow the pace of asset purchases. However, this was always anticipated, and the plan to buy an additional £150 billion of gilts by the end of 2021 was unchanged.
In my view this is a mistake. The additional gilt purchases were intended to offset downside risks to the economy (and hence to inflation) that have simply not materialised. Instead, almost all the usual inflation signals are flashing red. By the time that inflation expectations also break higher, it may be too late to act.
This article was first published by Reaction on 6th May 2021