Markets continue to struggle with the likely impact of the unprecedented monetary and fiscal policy measures taken to stem the coronavirus crisis, with every new effort to slow the spread of Covid-19 further deepening the impact on economies and societies.
In contrast with recently expressed concerns that central banks’ and governments’ trillion-dollar life-support measures will bring about a period of high inflation, I argue that inflation will not have to feature in a post-pandemic world.
Amount held by commercial banks matters most for inflation
While it is too early to tell if these unprecedented asset purchases by central banks will be inflationary, we should remember that it is not the size and duration of central bank asset purchases that matters, but the impact of those purchases on the amount of money held in the commercial banking system.
It is money in the hands of the public that creates inflation, not money on the books of the central bank. For example, in the period following the global financial crisis, central banks’ liquidity injections through purchases of securities in the markets – a process known as quantitative easing or QE – were widely thought to indicate the beginning of hyperinflation as central bank balance sheets ballooned to historic highs. In fact, though, the actions of the central banks only stabilised broad money growth, which would otherwise have declined. Inflation subsequently remained below 2% year-on-year in most developed economies.
In a modern economy, money is mostly created by commercial banks making loans. When banks grant a mortgage loan or a business loan, they write up a new asset and credit the deposit account of the borrower – literally creating the money out of nothing. The central bank has only a marginal involvement in this process, usually by setting a key interest rate which guides lenders and borrowers as to how much to lend or borrow. However, when the normal process of money creation by commercial banks breaks down, central banks need to step in to stabilise the system.
Different considerations during current crisis
This is what happened in 2008-09, and a similar dash-for-cash is behind the current credit squeeze. Faced with the prospect of lockdowns leading to the collapse of economic activity, disruptions to the payments system due to businesses being shut down, bankruptcies, and rising unemployment, any sensible business or individual immediately started calculating what funds they would need to tide them over until recovery came. This prompted a short-term need for liquidity that, as in 2008-09, would have been impossible for the banks to meet. Then as now, central banks had to step in and create the cash, deposits or liquidity demanded by firms and households.
These liquidity injections do not have to be inflationary. Historically, central banks acting as a “lender of last resort” have been able to gradually withdraw the excess cash or deposits from the banking system after the panic had subsided.
However, the coronavirus crisis is being addressed not just with expanding central bank balance sheets, but also with huge increases in government debt and deficits. The outlook for inflation after the coronavirus crisis will therefore depend on the nexus between monetary and fiscal policy, and the extent and circumstances of government debt being converted into money.
How money growth is achieved matters
If governments fund their fiscal rescue packages by issuing government debt instruments, this will be non-inflationary only if the funds are borrowed from the non-bank private sector in such a way that they do not create money.
However, when banks buy government securities, that creates money which in turn boosts total spending and, if continued for long enough, will lead to inflation. In the wake of the coronavirus crisis, therefore, the authorities will need to manage carefully the amount of government debt purchased by commercial banks if they are to limit broad money growth.
Budget deficits could also be financed by “printing money” – by keeping market interest rates or the exchange rate too low so that banks are encouraged to lend, or that a surplus on the balance of payments will produce an influx of funds from abroad.
Both more lending and an inflow of funds from abroad create additional deposits – that is, money – on the liability side of commercial bank balance sheets and could thus also prove inflationary.
Assessing the economics of the coronavirus pandemic so far, the Fed’s purchases of securities from non-banks and large drawdowns of credit facilities have had an immediate and striking impact on the broad money supply, which grew by over 60% p.a. on an annualised basis in the four weeks to 23 March.
If this growth rate of the broad money supply was to continue for a significant amount of time, say six to 12 months, then inflation in the US in the medium term will indeed start moving higher.
If, however, over the next three to six months this growth rate starts to fall to more normal, appropriate levels for an economy such as the US – that is, around 6-8% p.a. – there need not be a significant increase in inflation.
John Greenwood is Chief Economist of Invesco.