Inflation should be the least of our worries

The coronavirus pandemic and accompanying social distancing measures have thrown our lives into turmoil. We face serious concerns about our jobs, our kids’ education and our general sanity, not to mention the dire state of the economy. In this context, inflation should be the least of our worries. In the words of Federal Reserve Vice-Chair Richard Clarida, the ongoing health crisis is “disinflationary in the short- and medium-run.”

The economics of fear and sudden stops have been in full swing since early March. Consumer outlays have shrunk by one-fifth, while precautionary savings pushed the personal saving rate to a record high 33 percent in April. At the same time, businesses have slashed their domestic orders by a third, and cut around 20 million employees from their payrolls. 

The initial disinflationary impulse from these factors was clearly visible in April, when consumer and wholesale prices posted their largest monthly declines since 2008 and the core Consumer Price Index (CPI) experienced its steepest decline on record. Oxford Economics anticipates that the Fed’s preferred inflation gauge, core personal consumption expenditures, will fall from 1.7 percent at the start of the year to around 0.5 percent by the summer — the lowest reading ever.

Using an expectations-augmented Phillips curve approach, I find that the slack from the profound economic contraction and surging unemployment will be responsible for around 30 percent of the inflation slowdown in 2020, while lower energy prices would account for 25 percent, and a stronger dollar and reduced global inflation would represent 10 percent. Lower acyclical price inflation – goods for which demand generally isn’t correlated with income growth – will make up the remaining 30 percent or so of the shortfall.

But, while near-term disinflation isn’t widely debated, some have argued that the resumption of activity post-lockdown will stimulate demand faster than supply and inevitably lead to inflation. I doubt that will be true for several reasons.

First, the coronavirus shock represents the collision of the economics of fear and the economics of sudden stops. The decline in restaurant and bar outlays was at least as much driven by fear as by ordinances, since in-person dining fell even before social distancing measures were enforced. So, while a gradual reopening of the nation may lead to increased spending on goods and services that were previously inaccessible, we shouldn’t expect a sudden broad surge in demand for discretionary and social services. 

And while some pockets of higher inflation in goods prices may appear as supply chains gradually resume normal operations, these will be partly buffered by inventory drawdowns.

Second, the lack of pricing power is likely to represent a major constraint on inflation. Businesses’ pricing power was already declining, with the share of small businesses raising selling prices in 2019 steadily falling. Limited pricing power and soft final demand will mean businesses have scant ability to raise prices much. At the same time, depressed final demand and compressed profit margins won’t provide much room for higher wages, thus limiting prospects of a strong wage-inflation push.

Third, evidence shows that inflation expectations were sliding even before the global coronavirus recession, even as the economy neared full employment. With market-based inflation expectations falling further and consumer inflation expectations continuing to slide, runaway inflation seems unlikely.

Some commentators have also suggested that the combination of low interest rates and renewed quantitative easing (QE) by the Fed will cause spiraling inflation. They claim that as the Fed ramps up its QE purchases of Treasuries and agency mortgage-backed securities, this will prompt a corresponding rise in bank reserves held at the Fed, boosting the monetary base and leading to higher inflation. But in my opinion this monetarist view is outdated and misguided as the two key transmission channels from reserves to broad money, and from broad money to inflation appear extremely weak.

First, the “reserve multiplier,” which links the rise in bank reserves to money creation, has plunged dramatically since the 2008 financial crisis. Second, even though the stock of money has recently surged, its velocity – the speed at which money gets exchanged for goods and services – has also fallen uninterruptedly over the past 30 years, reaching a low point over the past month.

In an environment in which most of the private demand for credit is going to provisioning for loan losses at banks, or precautionary cash and liquidity for businesses (instead of capital investment), and where consumer demand for credit has fallen, we shouldn’t anticipate spiraling inflation.

Another line of argument is that the massive jump in government spending will inevitably produce excess demand, which will prompt higher inflation. This argument, however, misses the point.

While the $3 trillion of fiscal stimulus measures passed by Congress will lift the federal budget deficit and debt-to-GDP ratios to their highest levels since World War II, these measures are palliative rather than stimulative. Further, most of the measures are temporary, so once the economy recovers, government spending will fall in sync, preventing excess demand. 

In short, the more potent risk of runaway inflation comes from the politicization of the Fed. An environment in which the central bank permanently monetizes government debt by keeping interest rates artificially low and maintaining QE indefinitely could lead to runaway inflation, as was the case in the early 1970s. 

Fortunately, Federal Reserve Chairman Jerome Powell and the Federal Open Market Committee (FOMC) continue to display admirable resistance to this administration’s attempts to influence its decisions. If that continues to be the case, the Fed is well equipped to avoid any excessive overheating of the economy by swiftly tightening its monetary policy stance. 

Gregory Daco is the chief U.S. economist at Oxford Economics.