Economics

Why We Think the COVID Response Likely Won’t Ignite Inflation

Inflation fears didn’t come true after the global financial crisis and likely won’t now, in our view.

With the Bank of England (BoE) and other monetary institutions responding to the COVID-19 lockdown’s economic damage with trillions of pounds’ worth of lending and cash infusions into capital markets globally, we suspected it was only a matter of time before people started fearing a massive money supply increase fueling runaway inflation. Based on a slew of articles we have seen recently, that time seems to have arrived. Some of the concerns we have observed stem from unlimited quantitative easing (QE) asset purchases and the related increases in bank reserves, the mechanics of which we will discuss below. Others we have encountered take the recent jumps in various money supply measures in America, extrapolate them, and warn an uncontainable genie has left the bottle. We don’t think either case for turbocharged inflation withstands scrutiny, much as similar fears we observed during and after 2008’s global financial crisis didn’t pan out, as we will show.

The current crop of inflation fears do get one thing right, in our view: the focus on money supply. As American Nobel Prizewinning economist Milton Friedman summed it up decades ago, inflation is a monetary phenomenon of too much money chasing too few goods. Hence, major American money supply gauges’ recent surges amid a sudden halt in economic activity raise the specter of mountains of money chasing a very small pool of goods and services, making prices surge.[i] Whilst the focus is on American data since the Federal Reserve (Fed) releases money supply numbers weekly, making America’s the timeliest available amongst major nations, we have seen financial commentators apply similar logic toward the BoE and UK economy.

In our view, this ignores the larger factors at play. In an economic crisis, our analysis of history shows one of the biggest risks is money supply shrinking, which tightens credit and forces businesses to go under. The hints of that happening this time seem fairly obvious, including the sudden stop in businesses’ sales and reports of strains in the market for corporate debt issued by companies with lower credit ratings. Monetary policymakers have learned a lot since 1929, when Fed policy following the equity market crash reduced money supply and forced a grueling, years-long recession and bear market accompanied by deep deflation (period of overall falling prices for goods and services).[ii] That is what policymakers sought to stave off this time around. Rather than extrapolate the 24.8% y/y rise in American M1 (mostly paper currency, coins, bank reserves and checkable deposits) or 15.9% y/y rise in American M2 (M1 plus savings deposits, money market funds and CDs), as we have seen some financial commentators do, we think it is more logical to interpret the increase as a sign the Fed and other global monetary institutions aren’t repeating the early 1930s’ errors.[iii] Whatever else happens, with money supply not decreasing, we don’t think we are likely to see a prolonged deflationary decline.

Nor does our analysis suggest we appear to be on the verge of perpetually zooming money supply. Aside from new QE in the UK and America, most of the new programmes are a one-time event. They are also a substitution—not much money is changing hands right now, so central bankers stepped in to get funds to the businesses that are cash-starved from the lack of transactions. We aren’t going to call that a perfect one-to-one offset, but we suspect a lot of it probably cancels out.

In our view, what matters more for prices over the next few years isn’t how much the BoE, Fed and other central banks enable money supply to increase in the here and now—it is what happens after. Since these programmes are largely finite, it seems highly unlikely that money supply will continue galloping. Note, American M1’s last two jumps above 20% y/y, in 2009 and 2011, were also short-lived.[iv] Neither drove American inflation sky-high, either.[v]

If our past experience is any guide, some commentators will likely argue that even if the BoE and Fed don’t keep pumping new money, simply having all this new cash circulating once economies get back to normal will be enough to drive prices higher. Whilst that is conceptually possible, again, it didn’t happen the last two times. Plus, the Fed and BoE are charged with keeping inflation stable, and they have a number of tools at their disposal. Sopping up excess is as easy as raising reserve requirements. Raising short-term interest rates is another tactic.

That brings us to QE. Under it, central banks create bank reserves and exchange them for long-term debt held by banks. The aim is too boost bank’s reserves—which increases their capacity to lend—and lower long-term interest rates. In theory, this would boost demand for loans and cause money to circulate quicker, driving up inflation. But in practice, our analysis of recent history shows this often doesn’t come to pass.

America and Britain had several years of QE in the wake of the global financial crisis. In the US, inflation mostly hovered below the Fed’s 2% y/y target.[vi] UK inflation was higher at first, which we think stemmed from 2010’s VAT increase, but then it spent years below the BoE’s own 2% y/y target.[vii] Accordingly, many commentators we follow hypothesised that money supply no longer mattered to prices. Yet in our view, QE’s disinflationary track record shows money supply actually does matter—you just have to look at the correct measures. Years of QE did indeed boost the monetary base—notes, coins and bank reserves. But that is the narrowest money measure. The broadest, M4, includes everything in M2 plus everything that functions as money in the real world, including commercial paper. Whilst the monetary base soared in America under post-crisis QE, M4 didn’t. It fell on a year-over-year basis for a long stretch and crawled afterward.[viii] It didn’t accelerate noticeably until the Fed started signaling QE’s forthcoming end in mid-2013, enabling markets to price in a return to normalcy. UK M4 remained in negative territory for most of the BoE’s first QE programme, which ended in November 2012, then turned positive in early 2013.[ix]

The reason M4 didn’t soar in America or Britain? We think it is because banks create most of M4’s inputs through new lending. In our view, QE actually discouraged this because central banks’ purchases of long-term assets lowered long-term interest rates, reducing the difference between long and short-term rates. Banks borrow at short rates and lend at long rates, so the spread between the two represents their profit margin on each new loan. Therefore, our analysis shows reducing the spread diminishes the incentive to lend enthusiastically. That happened during QE, with various surveys showing banks kept credit standards tight. American loan growth during the expansion’s first several years was the weakest of any modern expansion.[x] UK business lending shrank for years.[xi] That tamped down money supply growth, keeping a lid on prices. A repeat this time wouldn’t shock us.

Mostly, we see the inflation fear renaissance as one more sign investor sentiment is worsening, as our research shows it typically does during a bear market (a prolonged, fundamentally driven broad market decline of -20% or worse). Looking for the reasons markets will fall further is a common endeavour as bear markets progress and people get gloomier. That gloom helps keep expectations down, creating a new wall of worry for shares to climb in the next bull market. We don’t know when that will begin—or if it has already—but whenever it happens, inflation fears may indeed form some of the wall’s first building blocks.



[i] Statement based on US Federal Reserve measures of money supply growth, as of 30/4/2020.

[ii] Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867 – 1960, Princeton University Press, 1963.

[iii] Source: St. Louis Federal Reserve, as of 27/4/2020. Year-over-year percentage change in M1 and M2 money stock for the week ending 13/4/2020.

[iv] Ibid. Year-over-year percentage change in M1 money stock, 31/12/2008 – 31/12/2012.

[v] Ibid. Statement based on America’s Consumer Price Index, a broad measure of consumer prices.

[vi] Ibid.

[vii] Source: Office for National Statistics, as of 29/4/2020. Statement based on the annual rate of consumer price inflation, known as CPIH.

[viii] Source: Center for Financial Stability, as of 29/4/2020. Statement based on the monthly year-over-year growth rate of M4.

[ix] Source: Bank of England, as of 29/4/2020. Statement based on the monthly year-over-year growth rate of M4.

[x] Source: St. Louis Federal Reserve, as of 29/4/2020.Statement based on US loans and leases in bank credit for all commercial banks.

[xi] Source: Bank of England, as of 29/4/2020. Statement based on sterling net lending to non-financial corporations.


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