A brief history of inflation as a monetary and political phenomenon

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.