We live in a world of the improbable. Black swans, fat tails, Brexit and Donald Trump remind us that the improbable is possible, sometimes even likely.
The same is true when it comes to inflation.
Say what?
Inflation has plummeted in the USA and Europe. Declines this year, from already low levels, followed the pandemic-induced 2020 collapse in economic activity. By most accounts, inflation will remain subdued for longer. The Fed and the ECB forecast inflation below their stated objectives over the next few years. The Fed’s median forecast has inflation barely returning to 2% by 2023, despite the central bank’s resolve for an overshoot. The ECB’s prognosis is even more sobering, with inflation still mired at 1.3% in 2022.
In our assessment, however, inflation risk is skewed to the upside. We base that conclusion, at the risk of looking foolish, on unfashionable monetarist theory.
The intuition is simple. Imagine that the amount of money in the economy doubles but production stagnates. Eventually, the adjustment will go through prices, which must double. The actual formulation is slightly more complex. Price increases will be driven by the difference between the growth of money and the growth of the real economy. To be precise, the velocity of money also matters. As financial sophistication increases, economies require more money for a given amount of activity, with the required monetary base increasing by about 0.5% each year in advanced economies.
Monetarist theory has been mocked abundantly. Little surprise, given the disconnect in recent decades between central bank balance sheet growth and, well, pretty much anything. The Fed’s balance sheet has ballooned from about $1.0 trillion in 2008 to $7.1 trillion today, an annual average rate of increase of 17% over a dozen years. Yet US nominal GDP (the sum of real growth and inflation) has risen by less than a third as fast over the same period.
The numbers are pretty much the same for the Eurozone. The ECB balance sheet has expanded at a 14% percent annual pace since 2008, over three times faster than the corresponding increase in nominal GDP. Even worse, Eurozone inflation has stagnated or even declined in the past decade, leading to more-of-the-same forecasts far into the future.
Why might monetarists be right this time?
Let’s begin with theory. What matters is money in circulation, used to purchase goods and services. The relevant monetary variables are the monetary aggregates, not the size of central bank balance sheets
Of course, the two are related, but the proverbial “printing press” is a misleading image. Money used for transactions is created by commercial banks, not central banks. When a bank lends, it credits the (current) account of the borrower with transactions money, thereby increasing the money aggregate.
But in the wake of the financial crisis, when central banks provided vast liquidity to support the financial system, much of that cash was immediately deposited back with the central bank for precautionary or regulatory reasons. In particular, regulatory changes pushed commercial banks to de-risk their balance sheets and incentivized them to build liquidity buffers. Borrowing and lending in the real economy remained subdued. In short, while balance sheets of central banks exploded, transactions financed borrowings were tepid.
Indeed, if instead of employing central bank balance sheet size, we use transactions money in our monetarist framework observed inflation outcomes are much closer to what theory would expect.
For example, a transactions money based model would have forecasted annual average US inflation of 3.4% since 2008, which, to be sure, was still an overshoot over recorded inflation of 1.7%, but much closer than outcomes based on central bank balance sheet numbers. Over longer horizons, the monetarist arithmetic is even better, forecasting average annual US inflation since 2000 of 2.2% versus 1.9% realized. For the Eurozone, the model is even better over the past decade, forecasting a 1.4% annual rate of inflation, a smidgen over the realized 1.3% rate.
The conclusion is that it is premature to consign the monetarist model to the dustbin. It remains a useful framework, particularly for medium-term inflation analysis.
More important, the model could prove highly relevant in the years immediately ahead. Recall that ‘money’ did not cause much inflation in the past decade because the transmission mechanism broke down due to insufficient lending. It may be unwise to extrapolate that irregularity too far into the future.
After all, the policy response to the Covid-19 crisis includes incentives for commercial banks to lend. State guaranties on new loans have reduced the risk for banks. Regulators on both sides of the Atlantic have eased constraints on bank lending. Transactions money aggregates are growing at 23.3% and 9.5% annually in the US and Eurozone, respectively. Even if velocity is declining more than trend, inflation could easily accelerate as output gaps narrow.
This is not an argument for surging 1970s style inflation. Nor is it about inflation taking off soon. As no less a monetarist than Milton Friedman once said, lags between money and inflation are long and variable.
Nevertheless, inflation heading toward 3% is plausible. Yet even that modest acceleration is utterly unanticipated by central banks or financial markets, where long-term expectations are much more subdued. Markets are priced for inflation to return to 2% after a half decade in the US and only after more than two decades in Europe!
Even modestly higher inflation could produce a dramatic repricing of bond markets, yield curves and almost every other financial asset. Higher average inflation would also erode the nominal stock of debt inherited from the financial and corona-virus crises. That’s certainly a very different scenario than the one currently anticipated by investors and central banks.
The unexpected can happen. Tail events are more likely than generally believed. And when a workhorse model predicts what others believe to be a ‘black swan’, it’s worth sitting up and taking note.