A brief history of inflation as a monetary and political phenomenon

Christopher Dembik

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.


Most economists consider that the most powerful leading indicator for inflation is M2 money supply. It is fair to say that we have never experienced in the past, not even during the 1970’s stagflation, money supply growth as high as it is today in COVID-times, skyrocketing at more than 20% YoY.

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.


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