A brief history of inflation as a monetary and political phenomenon
Head of Macro Analysis
Summary: Since COVID-19, we have seen a series of upside surprises in inflation data, notably in emerging markets and in food prices, that mostly reflect the major imbalances related to the pandemic and the global lockdown. However, we cannot rule out the risk of inflation overshooting in the coming years due to a sudden change in the regime shift.
There is certainly no theme more important than inflation in the macroeconomic space right now. All the clients and the asset managers are sharing their worries about the inflation risk and are looking for investment strategies to hedge against inflation, often favoring gold (paper or physical) or other commodities. Since COVID-19, we have seen a series of upside surprises in inflation data, notably in emerging markets and in food prices, that mostly reflect the major imbalances related to the pandemic and the global lockdown. However, we cannot rule out the risk of inflation overshooting in the coming years due to a sudden change in the regime shift. In order to address this hot issue for investors, we discuss in a Q&A format the reasons that led to the Great Inflation, structural factors affecting the evolution of inflation and our inflation outlook for the coming years.
Q. What are the main factors that caused the Great Inflation (1965-1982) ?
A. Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”. Today, this statement is usually accepted by all the economists. If we look back in time we find out it perfectly explains the main cause behind the surge in inflation in the 1960s and 1970s in the developed world. In the United States, the Federal Reserve followed from the 1950s and early 1960s a “lean against the wind” monetary policy (or too-loose monetary policy) that had a dramatic effect on the economy and the level of inflation. Basically, policymakers at the Fed misjudged how hot the economy could run without increasing inflation pressures and when CPI started to rise, the monetary response was too slow. Higher oil and food prices also exacerbated the issue. To get out from the Great Inflation and take back control, the Federal Reserve had no other choice but to drain off the excessive liquidity by sharply increasing interest rates, which caused the 1982-83 recession, and to commit to stable growth in the money supply.
Q. Nowadays, despite a massive surge in money supply, inflation remains subdued. How do you explain that ?
A. Many studies underlines the fact the relationship between the evolution of inflation and the money supply is stronger over the medium and long term. It means that in the short term some factors can considerably affect the quality of the transmission. In the present case, there are at least five main reasons pushing inflation down:
1. The strong decline of both the money multiplier (the amount of money that banks generate with each dollar of reserves) and money velocity (the rate at which money is exchanged in the economy). It can be partially explained by regulatory constraints on the banking and financial sector and weak demand for loans reflecting that things are not as good as the financial markets appear to be telling us.
2. Inequality. Studies proved that low inflation rates are generally associated with higher income inequality, without explaining quite well the process at work.
3. Globalization. Global value chains tend to induce the existence of strong cost-reduction and wage moderation associated with rising productivity and declining competition (rising market power especially in services sectors).
4. New technology. All the technological revolutions are basically deflationary as they allow for more intensive use of resources leading to higher production and a fall in prices of goods.
5. The absence of policy mix before the pandemic. Some countries favored in the recent years a tight fiscal policy which has had large negative multiplier effect on the economy, notably on aggregate spending, while monetary policy was expansionist.
Q. What is the impact of the pandemic on inflation in the short run ?
A. There is a large consensus among economists that the initial COVID-19 shock is a massive disinflationary impulse which is accompanied by a lot of data noise, especially reflecting habits shift in consumption. In the short term, it is certainly wise to consider that the evolution of underlying inflation is not properly measured and weighted in CPI. We better refer to CPI only as a way to capture what the pandemic has done in terms of changing consumer behavior. This is particularly salient when looking at change in durable consumption versus service consumption. For instance, we spend less on transportation and eating out in these unusual circumstances while at the same time we have seen food prices jumping quite a lot for some items at the supermarket.
Q. If we look beyond the initial deflationary shock, what is the outlook for inflation ?
A. Referring to Milton Friedman, I have mentioned that “inflation is always and everywhere a monetary phenomenon”, at least in the medium and long term. But we should not forget that inflation is first and foremost a political phenomenon. Its evolution in the coming years will highly depend on future policy decisions that will be taken after the crisis. At Saxo Bank, we believe there is a case for inflation overshooting, let’s say in the next 12-18 month horizon. If we combine redistributive policies to fight against rising inequality with supply chain relocation and protectionism, without forgetting the strong jump in money supply growth, we have almost a perfect inflation narrative for 2022 and beyond that can temporarily overwhelms deflationary forces driven by the factors we have mentioned previously.
Latest Market Insights
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.