Most investors came of age during a persistently disinflationary environment. Given the disinflationary demand shock caused by the coronavirus pandemic, that backdrop is likely to endure for the next several years. However, the combination of massive unconventional monetary policy and the increasing willingness of policymakers to take advantage of historically low interest rates and embrace the aggressive use of fiscal policy could eventually set the stage for a medium-term shift in the inflation backdrop.
How Do The GFC And COVID Crises Differ?
Despite an enormous monetary policy response to the global financial crisis (GFC), inflation remained historically very low. Why? In my view, there are two primary reasons: low money velocity and heavy deleveraging by banks, households and, eventually, governments. But that was then and this is now. The conditions surrounding the GFC are quite different from those we face today.
In reaction to the GFC, the US Federal Reserve and other global central banks printed oodles of money in order to thaw frozen credit markets and revive economic growth. But much of that money did not get into the system and the velocity of money—the frequency with which money changes hands in a given period—fell sharply. The reasons for this were the deleveraging and risk aversion. As the crisis unfolded, banks shed bad assets, homeowners defaulted on mortgages and governments adopted fiscal austerity too soon, all while the economy was struggling. Households, banks and corporations, scarred by the crisis, were eager to hold cash, thus the money that did make it into the system sat idle, changing hands infrequently and thus restraining inflation. So what we learned from the prior crisis is that the supply of money alone won't kindle inflation and that demand plays a very important role.
Why This Time Might Be Different
1. The policy response has been immense and swift: The scope of the global policy response to the pandemic, both monetary and fiscal, far eclipses earlier episodes. Additionally, today's aid is more focused on getting the money into the broader system, concentrating on Main Street more than Wall Street and on households and businesses rather than financial institutions. Moreover, while the pandemic is far from over, the banking system has thus far not been forced to deliver, unlike during the GFC.
2. Policymakers are unlikely to commit the same mistake again: The question will be whether fiscal policymakers repeat the error they made following the GFC, when they adopted austerity early in the expansion, beginning around 2011. Today, that premature belt-tightening is viewed as a mistake, especially in Europe, where a sovereign debt crisis subsequently engulfed the eurozone. Perhaps deteriorating debt profiles will force aggressive fiscal austerity again, but with yields pegged at (or below) zero, there should be additional scope to forestall fiscal normalization.
3. Politicians may be thinking the unthinkable: Though there is a reluctance on the part of many officeholders to embrace Modern Monetary Theory (MMT) by name, some are increasingly comfortable adopting parts of it in practice. MMT asserts that a country can issue huge amounts of sovereign debt with little or no negative ramifications if it 1) can issue debt in its own currency, 2) has a very large negative output gap (that is to say that its economy is running at well below potential) and 3) can finance deficits at close to zero cost. While such an idea was until recently unthinkable, one consequence of the pandemic has been an opening of the Overton Window, which describes the range of policy ideas the public, and policymakers, are willing to entertain. The scope of the economic damage wrought by the pandemic appears to have forced the window wide open.
4. It looks like we're monetizing the debt: A further factor that seems different this time is the extent of the Federal Reserve's monetization of US Treasury debt. While there are important semantic disagreements over what constitutes monetization, the combination of accelerating sovereign debt issuance with heightened central bank buying of that debt raises a red flag. But not all prior episodes of heavy Fed government debt purchases have resulted in inflation. Fed buying of Treasuries during the two world wars coincided with inflation, while the GFC episode did not. Here's why: During the world wars, there were positive output gaps (the economy was operating above full capacity) and the money being printed was making its way into the broader economy, which was the exact opposite of what happened during the GFC. The adoption of something resembling MMT on a sustained basis, coupled with debt monetization and a closed output gap, could upend the disinflationary dynamics of recent decades.
5. Inflation expectations could become unmoored: Inflationary expectations have been well anchored in recent decades, but that has not always been the case. Expectations plummeted during the Great Depression, and they vaulted higher in the 1970s. A change in psychology in response to new policies along the lines of MMT and debt monetization can't be ruled out. Alternatively, if we repeat the post-GFC mistake of imposing fiscal austerity too soon, we could potentially see inflation become unanchored to the downside. In either case, the Fed will need to be careful not to lose credibility.
6. Governments would welcome some inflation: How have countries historically reduced unsustainable debt burdens? The surest way is through default, but that's clearly not an option for the US or other highly rated developed countries. The preferred method is to grow your way out, with GDP rising faster than debt, reducing debt as a percentage of GDP. Against a low-growth background and deteriorating demographics, the prospects of growing our way out of debt are poor. Another way to try to address an unsustainable debt profile is via austerity, but as we've laid out above, that can be self-defeating. Countries can also attempt to depreciate their currency as a way out of debt, but if all trading partners did so at the same time, this would serve no purpose, as every currency can't fall at once. Financial repression, which is "artificially" holding sovereign rates lower than nominal GDP growth, is another method, and one authorities have been trying for years with only limited success. All this having been said, the one method that we truly haven't tried is inflating our way out. Yes, central banks printed a lot of money during the last crisis, but deleveraging undermined the path toward higher inflation. However, if policymakers open the Overton Window wide enough and add MMT and debt monetization to their toolkits that combination might sustainably lift inflation rates to levels we've not seen in more than a generation and enough to lighten the country's debt load over the coming years.