The Spectre of Inflation

The world is in the midst of the greatest monetary experiment of all time. Policymakers combatting the fallout from COVID-19 have pumped unprecedented stimulus into the global economy. Unconventional monetary policy, central banks only used under the gravest circumstances, has become the norm. Prominent academics, policy makers, and executives worry about resurgent inflation coming out of the pandemic citing the stagflation crisis of the 1970s. Here in Canada, the CEO of RBC believes that next year, rising inflation will force central banks to raise rates, contrary to the latest announcements by major central banks. So where is inflation? Will it return in the 2020s?

Traditionally, determining whether inflation would occur is determined by comparing actual to potential GDP. For nearly a decade, developed economies have operated below potential capacity, and policymakers have struggled to find a solution. Many attribute this to sluggish demand. That is expected to change with the recent stimulus out of the United States, which has come under criticism by Obama’s National Economic Advisor. With an output gap of 3% and 9% fiscal stimulus, Larry Summers believes the risk of inflation greatly exceeds what it has been since the Volker Recession of the 1980s. However, there is disagreement. We saw little inflation over the last decade; why would we see it now? At nearly 11%, David Rubinstein points out that the broadest measure of unemployment in America is well above the pre-crisis level and wage growth continues to fall short of productivity. The current Treasury Secretary and former Fed Chairman, Janet Yellen, also believes that inflation risks are overblown. Who is right?

It will be a while until the world knows. In the next few months, most countries will see sustained inflation, but the real question is whether these rising prices are permanent or temporary. The second quarter of 2020 saw falling prices, so any year over year comparison will show high inflation, something known as base year effects. Whether or not this inflation is permanent, or the shocks from pent up demand and government stimulus are transitory depends on something fundamental to monetary economics; money velocity.  

Since 2008, the federal reserve has doubled the money supply. To the dismay of many, prices rose only 22% because money velocity fell. Money velocity is the number of times every dollar in the economy is spent annually. In 1981, American money velocity was 3.5, today it is just once. Thus, more money is needed to sustain economic activity at the same level. To determine if inflation is only a transitory risk or here permanently, one needs to predict money velocity post pandemic. Ironically, velocity may depend more on the minimum wage debate in the United States or the $15/hour wage proposed in Canada’s most recent budget, than the size of any temporary stimulus. 

The speed at which money flows through the economy depends on who holds it. The poorest in society spend money just as fast as they make it, and about half of Americans and Canadians live paycheque to paycheque. With no savings, that means a large portion of consumers have high money velocity because they spend money as fast as they make it. With consumption making up over half of GDP, this consumer spending makes up a large direct portion of how money velocity changes. According to data from Statistics Canada, the lowest 20% of earners spend their cash holdings 30 times annually. This is in contrast to the top 20% of earners spends who spend it only eight times. Money velocity thus falls as income rises and becomes less than one for those earners in the top 1%. As inequality grows, money holdings accumulate in the accounts of people with lower money velocity and thus falls overall in the economy. 

Traditionally, this should not be a problem if savings are recirculated through the economy via financial markets. However, corporations have been reluctant to make investments due to the lack of demand and see dividend recaps and share buybacks as a more favourable option when taking advantage of low interest rates. 

A permanent increase in inflation would require a sustained increase in money velocity. Thus, with the economy’s plumbing clogged, persistent inflation remains unlikely. 

That does not negate the very real asset inflation markets have witnessed since 2020. With the S&P 500 up nearly 25% relative to its pre-pandemic highs and Canada's housing market in a “huge bubble", it is clear once again there is no free lunch in economics. Money velocity only accounts for expenditure in the real economy and is not counted when it comes to the acquisition of financial assets. Too much money chasing too few assets has propelled the Schiller’s PE ratio on the S&P 500 to levels not seen since the late 1990s. It is very possible for valuations to continue to skyrocket for years to come under QE. The current monetary transmission mechanism in the wake of Reaganomics will never be able to sustain permanent inflation of goods and services because that is not where the money is going. Even with helicopter money effectively becoming government policy, this will only have a transient effect on spending. Inflation will not pick up unless we think it will. 

There is cause for concern that expectations may lift inflation for some time. 

Unlike the sophisticated investors and institutions who search for any minor detail that central banks may include in their statements, many people and businesses seem “unaware of even dramatic monetary policy announcements, and more generally display almost no knowledge of what central banks do” according to economists’ findings at the University of Chicago. After nearly four-decades, inflation expectations are anchored near zero. There is a risk that the transient spikes in inflation erupting from the large government stimulus in the economy adjusts inflation expectations upwards leading business managers to increase prices at a faster pace than previous years. However, this would also prove unlikely to last because productivity continues to exceed wage growth, and higher prices will result in falling sales as demand remains flat. However, with the recent introduction of Canada’s inflation adjusted federal $15/hour minimum wage, inflation expectations will mechanically rise over time in Canada. 

Regardless of what happens to inflation over the next decade, the traditional view of what causes rising prices must change. With more data and computing power than ever, economists no longer face the constraints they did in the 19thand 20thcenturies. Individual level data can help both policymakers and academics develop superior models and solutions which will benefit millions of lives. Assumptions such as representative agents which do not hold because households and firms are heterogenous and suffer from compositional changes over time must be adapted and studied if western economies are to prosper in the 21st century.