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Authors: Daniel Ho Region Head: Saumya Rajawat
Editor: Harsh Didwania
Abstract
On March 11th 2021, Joe Biden’s signed his 1.9 trillion stimulus package into law. The plan, officially known as the “The American Rescue Plan” was the latest effort by the US government to prop up the battered economy. Together with the CARES Act last year, US public spending has pushed debt past 28 trillion (US Debt Clock, 2021). On top of this, Biden intends to pass two other massive spending bills which will push his administration’s spending past 6 trillion (Thrush, 2021). The unprecedented amount of fiscal stimulus has brought back fears of an age-old economic problem, inflation. Are these fears warranted or unjustified in this new age of economic thinking?
Out with the old, in with the new
Monetarism, popularised by Milton Friedman in the 1980s suggest that rapid expansion of the money supply will lead to uncontrollable inflation. Economic growth is a function of economic activity and inflation. An increase in the money supply without a concomitant rise in goods and services produced will lead to rampant inflation (Ganti, 2021). The hyperinflation of the 70s was the clearest vindication of this theory. However, by the 90s, Monetarism fell out of favour with economists and a new Keynesian framework emerged in its place. The new theory proposes that inflation is driven primarily by dovish inflation expectations and a tight labour market (The Economist, 2020). Expecting higher prices is a self-fulfilling prophecy as consumers rush to secure low prices. A healthy labour market bids up wages and result in cost-push inflation. Both of these factors are absent from the current economy. The latest survey shows that Americans still expect the inflation rate to stay well below 2% (Federal Reserve Bank of Cleveland, 2021) while the labour market still has much runway before a healthy recovery is observed. The output gap that currently exists also give firms little incentive to raise wages, thus suppressing prices. While the current literature sees inflation as a tail risk, there are at least three trends that portend a brewing storm, the nature of the current crisis, deglobalisation and independence of the central bank.
A false equivalence
Sceptics of runway inflation often brush away these fears with the US experience of low inflation after the global financial crisis. However, the catastrophe back in 2008 originates from a credit crunch caused by the high percentage of defaults on sub-prime mortgages. Pumping new money into the economy merely made up for shortfalls in bank lending (The Economist, 2020). Today, banks are flooded with cash so are households. When lockdowns begin to ease, firms with limited production capacity might not be able to keep up with the demand by cash strapped consumers who have already signalled a strong spending appetite. In the first quarter of 2021, personal consumption expenditures have risen by 10.7% on an annualised basis (York, 2021). The magnitude of quantitative easing also differs. “Broad Money” or M2 which includes savings deposits and the value of retail money market mutual funds have soared in 2020 (Corporate Finance Institute, 2021). More than 24% of the total money supply in the US was created in 2020 alone compared to just a 9.73% increase in 2008 (see figure 1). The scale of intervention today far supersedes that of 2008 and our experience over the past decade cannot be taken as an absolute refutation of monetarism.
Figure 1. M2 Money Supply of US
Deglobalisation
Another factor to consider is deglobalisation. In the Great Demographic Reversal, Charles Goodheart lays out the main explanation for low inflation in the past decade. The rise of China over the past decade heralded an era of unprecedented interconnectedness and freedom of labour. Globalisation enabled firms to source their workforce and as a result, relocate their production to anywhere in the world. The existence of a cheap labour supply from East Asia has prevented prices from rising. However, all of these are due to reverse as China, the biggest driver of globalisation, now faces an ageing working population. The same trends are observed in virtually all developed economies including the US. The impending supply shortage both at home and abroad should restore some of the bargaining power to workers in the US and result in higher wages (Goodhart & Pradhan, 2020). Aside from demographic shifts, deglobalisation is also caused by the waning appetite for a neoliberal global order. Protectionism is now back in fashion as the West sought to prioritise their domestic interests ahead of international responsibilities. Hostility between the US and China as evinced by the trade war impinges on the freedom of labour and capital. Add Covid-19 into the mix, we could expect a much more localised economy and an end to the fragmentation of the production process. The dearth of cheap labour and inputs offered previously by transnational commerce means that consumers will have to bear the ultimate price.
A not so independent central bank
Following hyperinflation in the 70s, central banks enacted the “Volcker Shock”, a shorthand for raising the interest rates sharply (see figure 2). During that time, the only prerogative within the central bank’s playbook was to tame inflation through contractionary monetary policy (Amadeo, 2021). In today’s climate, Federal Reserve’s main priority is to reduce unemployment. Such a drastic shift came as central governments emphasise the poor and the most vulnerable. The Fed has accepted overshooting the 2% inflation target as a reasonable trade-off in its quest to achieve full employment (The Economist, 2021). In recent years, the Fed has signalled a willingness to comply with the administrations bidding by keeping the interest rate low. As the pandemic rages on, it is “highly unlikely” for the Fed to raise interest rate this year says Jerome Powell (Cox, 2021). Inflationistas argue that hubris of the central bank and political strong arming by the government will reproduce the intractable inflation in the 70s.
Figure 2. Inflation and Interest Rate in the US
Remember Black Swans?
There are few issues where economists disagree more than inflation. Historically, Keynesian and Monetarist economics take turns to dominate the mainstream view. Right now, the consensus seems to side with the former. While the probability of hyperinflation may be low, the risk is much greater today. The mountain of debt that has piled up dramatically over the past year has made the US economy much more susceptible to interest rate risk. Should the Fed be forced to enact a “Volcker Shock” to tackle hyperinflation, the consequences would be unthinkable. If Covid-19 served as a sobering reminder that we should never disregard tail risks, America’s unfettered spending should be no different.
References
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