Inflation after COVID-19
There is currently a debate raging amongst financial analysts, economists and other policymakers about whether or not the macroeconomic environment after COVID-19 will be a deflationary one, similar to the aftermath of the 2008 financial crisis, or if it will be inflationary given the new measures that have been taken. The basic premise of the deflationary argument is that all sectors of the economy are shut down and there is a massive debt load that will weigh heavily on all parts of the economy, increasing deflationary pressures. The basic premise of the inflationary argument is that the economy, while suffering and currently deflating due to confinement measures, has large areas of pent-up demand lurking as incomes have been more or less protected due to large fiscal policies and stimulus measures taken directly to the consumer. Only time will truly answer this debate as economies open up and confinement measures are gradually reduced.
I will make the assumption for the purpose of this analysis that there will be a strong inflationary burst after COVID-19. I will be looking at the last true inflationary environment the US has really suffered as a proxy: The Great Inflation of the 70s and early 80s. I will be discussing if there are lessons worth drawing from the period that could help understand what could happen today and could guide what to do.
The Great Inflation: A Historical Primer
For an excellent and detailed review, please see Allan Meltzer’s “Origins of the Great Inflation”. Essentially, the Federal Reserve at the time was overly reliant on a ‘simple’ model that did not take into consideration the effect of money supply on inflation, nor did it have an overarching theory that inflation was factored into. These issues were exacerbated through two main mechanisms that stroked inflation out of control. The first being that the Federal Reserve was not raising its interest rate high enough to combat inflation. It was raising it in line with the rise in inflation, tracking the nominal rate, not the real rate.
The Federal Reserve did this partially due to the politicians’ desires to encourage full employment rather than deal with inflationary pressures. President Nixon is a prime example of this desire, where his cabinet was aware of the inflation issue but chose to not deal with it and focused on jobs instead. The second reason was that the role of the Federal Reserve was slightly different from what it is today. The Federal Reserve bore co-responsibility regarding government debt issuance and management, thus making itself responsible for ensuring that issuances were accepted at the announced rate, which led to financing and encouraged the growth of inflation. This is in contrast to today where the Federal Reserve no longer holds this co-responsibility and the government debt is issued and accepted at whatever rate the private market determines. These issues led to an increase in the unemployment rate and the inflation rate causing economic hardship to millions of Americans who either were not getting a salary or seeing their salary become increasingly worthless.
The End of the Great Inflation Era
The aforementioned challenges and issues were ultimately dealt with by an incoming Federal Reserve Chairman who previously worked at the Federal Reserve Bank of New York and the Treasury, Paul Volcker. Volcker was clear about his goals and how far he was willing to go. He knew that employment may suffer if his plan was to work, but he was willing to go through this difficulty to defeat what he viewed as the larger problem if left unchecked: Inflation. Volcker rose the interest rate to an average annual rate of 16.39%, with a peak of a monthly rate of 22% at the end of December 1980. Volcker knew that by reducing the velocity of money and raising the interest rate, i.e. decreasing how often money changes hand in a specified amount of time and reducing the ease of getting money, he would be making borrowing expensive and savings worthwhile, which would curb inflationary pressures. His action did trip the American economy into a recession, but afterwards the American economy did not have a high inflation problem and the period that is known as a Great Moderation began, which ended with the 2008 recession, otherwise known as the Great Recession.
Lessons for the Modern Day
Much has changed since the 70s and 80s: in the economics profession, the management of the Federal Reserve, as well as in the changing composition of the United States economy. It is unlikely that the issues of the 70s and 80s, or the speed of the rise of inflation would reoccur today. The difficulty for the modern-day would be that there is a whole generation of consumers who do not know what it is like to live in an inflationary world, especially after the low rates, low inflation environment the global economy has experienced since the aftermath of the 2008 recession. If there would be an inflationary burst above the current of 2%, it would be shocking given how anchored people’s expectations are about the levels of inflation they have experienced. There is an argument to be made that the Federal Reserve would allow the inflation level to rise above the 2% for a period of time to help lessen the debt load that has dramatically increased in response to the global pandemic/economic crisis. Rising inflation will make previously issued debt easier to service, as the value of a dollar of yesterday gradually decreases. The rising inflation threat would also help push interest rates back to a level that the world saw before 2008 which could give more ammunition to conventional monetary policy, i.e. the manipulation of interest rates to change the supply of credit. Of course, there are risks to this strategy, chiefly the loss of confidence that consumers have in the inflation expectations the Federal Reserve will try to set. This would remove the anchor that the Federal Reserve tries very hard to create and in which inflation has been targeted around since the introduction of inflation-targeting as a tool. This is clearly on the mind of people at the Federal Reserve, with the New York branch just releasing work about it. They found that expectations have not changed as of yet, but that uncertainty regarding inflation is rising and the expectations of an extreme inflation event such as deflation or high inflation to also be rising. This is uncertainty is what feeds into this analysis. This could be combatted through effective communication by the Federal Reserve of an upward revision of inflation targeting to something like 4% instead of the current 2%. This is not as outlandish as it may seem with research presented by institutions like the IMF or PIIE.
In summary, the risk and expectation of an extreme inflation event is rising and awareness of it at central banks is rising in response. The last extreme inflation event, the 1970s, while an interesting point in economic history does not appear to hold many lessons for the modern day due to the complete change in the management of central banks. The only lesson that could be drawn is the unfortunate trade-off between employment levels or inflation. Due to the global crisis, there are already extraordinary levels of unemployment in economies across the world that make any decision an even more painful one. The question will be what central banks will deem to be a high enough level of inflation to throttle, or would they even believe desirable to further damage employment outcomes. Only time will tell.
