TThere is a growing debate here about whether the inflation that will emerge in the coming months will be temporary, reflecting the strong rebound from the Covid-19 recession, or persistent, reflecting both demand and cost push factors.
Several arguments point to a persistent secular rise in inflation, which has remained below the 2% annual target of most central banks for more than a decade. The first argues that the United States has enacted excessive fiscal stimulus for an economy that already appears to be recovering faster than expected. The additional $ 1.9 trillion (£ 1.4 trillion) of spending approved in March added to a $ 3 trillion package last spring and a $ 900 trillion stimulus in December, and a $ 2 trillion the infrastructure bill will follow soon. The United States’ response to the crisis is therefore an order of magnitude greater than its response to the 2008 global financial crisis.
The counterargument is that this stimulus will not trigger lasting inflation, because households will save a large part of it to pay off their debts. Furthermore, investments in infrastructure will not only increase demand, but also supply, by expanding the stock of public capital that improves productivity. But of course, even taking these dynamics into account, the rise in private saving brought on by the stimulus implies that there will be some inflationary release from pent-up demand.
A second related argument is that the US Federal Reserve and other large central banks are being excessively accommodative with policies that combine monetary and credit easing. The liquidity provided by central banks has already led to short-term asset inflation and will drive inflationary credit growth and real spending as the economic reopening and recovery accelerates. Some will argue that when the time comes, central banks can simply absorb excess liquidity by reducing their balance sheets and raising policy interest rates from zero or negative levels. But this claim has become increasingly difficult to accept.
Central banks have been monetize large fiscal deficits in what amounts to “helicopter money” or an application of Modern Monetary Theory. At a time when public and private debt is growing from an already high baseline (425% of GDP in advanced economies and 356% worldwide), only a combination of low short-term and long-term interest rates can keep the debt burden sustainable. Normalizing monetary policy at this point would collapse the bond and credit markets, and then the equity markets, causing a recession. Central banks have effectively lost their independence.
In this case, the counterargument is that when economies reach full capacity and full employment, central banks will do whatever it takes to maintain their credibility and independence. The alternative would be a de-anchoring of inflation expectations that would destroy its reputation and allow uncontrolled price growth.
A third claim is that the monetization of fiscal deficits will not be inflationary; rather, it will simply avoid deflation. However, this assumes that the shock that hit the world economy resembles that of 2008, when the collapse of an asset bubble generated a credit crunch and, therefore, an aggregate demand shock.
The problem today is that we are recovering from a negative aggregate supply shock. As such, too lax monetary and fiscal policies could lead to inflation or worse, stagflation (high inflation coupled with a recession). After all, the stagflation of the 1970s came after two negative oil supply shocks that followed the 1973 Yom Kippur War and the 1979 Iranian Revolution.
In the current context, we will have to worry about a number of potential negative supply shocks, both as threats to potential growth and as potential factors that drive up production costs. These include trade obstacles such as deglobalization and growing protectionism; post-pandemic supply bottlenecks; the deepening of the Sino-American cold war; and the consequent balkanization of global supply chains and the relocation of low-cost foreign direct investment from China to higher-cost locations.
Equally worrisome is the demographic structure in both advanced and emerging economies. Just when older cohorts are boosting consumption by spending their savings, new restrictions on migration will put upward pressure on labor costs.
Furthermore, growing income and wealth inequalities mean that the threat of a populist backlash will continue to play out. On the one hand, this could take the form of fiscal and regulatory policies to support workers and unions, another source of pressure on labor costs. On the other hand, the concentration of oligopolistic power in the business sector could also be inflationary, because it increases the pricing power of producers. And, of course, the backlash against “big tech” and capital-intensive, labor-saving technology could reduce innovation more broadly.
There is a counter-narrative to this stagflationary thesis. Despite public reaction, technological innovation in artificial intelligence, machine learning, and robotics could continue to weaken the workforce, and demographic effects could be offset by higher retirement ages (implying a greater job supply).
Similarly, the current reversal of globalization may be reversed as regional integration deepens in many parts of the world and service outsourcing provides solutions to obstacles to labor migration (a programmer in India does not have to move to Silicon Valley to design a US application). Finally, any reduction in income inequality may simply military against tepid demand and deflationary secular stagnation, rather than being severely inflationary.
In the short term, slack in the markets for goods, labor and raw materials, and in some real estate markets, will prevent a sustained increase in inflation. But in the coming years, lax monetary and fiscal policies will begin to unleash persistent inflationary, and eventually stagnant, pressure due to the emergence of a series of persistent negative supply shocks.
Make no mistake: a return to inflation would have serious economic and financial consequences. We would have gone from the “Great Moderation” to a new period of macro instability. The secular bull market for bonds would eventually end, and rising nominal and real bond yields would make today’s debts unsustainable, crashing world equity markets. In due course, we might even witness the return of 1970s-style malaise.
Nouriel Roubini is a professor of economics at New York University’s Stern School of Business. He has worked for the IMF, the US Federal Reserve, and the World Bank.
George is Digismak’s reported cum editor with 13 years of experience in Journalism