I promised to address common criticisms of my inflationary outlook detailed in Part 1. This piece attempts to do so, including responding to some of the points made by sharp-eyed readers on LinkedIn.
To summarize Part 1: I believe that a dramatic shift took place in 2020 in the policy response to economic recessions, with the incorporation of large-scale Modern Monetary Theory (MMT)-financed fiscal transfer payments. At some level of cash transfers into the economy, the transfers are almost certainly inflationary (if we gave a typical household USD 34,000 of printed money instead of USD 3,400, prices would rise), and the mechanism for financing the payments has no size constraint. MMT-financed fiscal transfers may prove difficult to phase out because the effect of the ensuing fiscal cliff may be a dramatic headwind to growth and potentially recession-inducing. For now, inflation is viewed (perhaps rightly) as a positive outcome of the fiscal response if it does occur, and as a result, the inflation “risk” was not a source of hesitancy to enact the latest fiscal transfer package. If forced to decide, I think that upward price pressure is imminent because at the same time that the latest stimulus payments are going out, the Treasury General Account will draw down, resulting in a period of helicopter money effect on the U.S. economy. Also, discussions of herd immunity will potentially be taking place very soon, both because vaccine progress is accelerating and because the improving coronavirus statistics are increasingly clarifying what the health care establishment seems hesitant to verbalize: Vaccines inhibit transmission, not just severe illness, and prolific prior COVID-19 exposures confer individual immunity sufficient enough to inhibit community spread. All of this, to me, is a recipe for upward consumer price pressure (which was the focus of my first piece), as well as a durable burst of real economic growth: the so-called reflationary environment.
The criticisms of my view fall into a number of buckets, which I’ll try to address in turn: 1) inflation is more or less impossible when an economy has a lot of labor market slack, meaning when there is a large stock of unemployed labor, as we have now; 2) there is the potential for significant movement under the surface in the inflation statistics that will prevent inflation in aggregate, because for every component that will see demand on an economic reopening (e.g., airfares and hotels), there is a corresponding offset in a lockdown-affected sector like home improvement, for which price increases will slow down or even reverse; 3) large debt overhangs are inherently deflationary, as we have seen in Japan—therefore, inflation should be restrained, because the fiscal response to COVID-19 has flagrantly increased the size of government debt overhangs in the U.S. and abroad; and 4) demographic and structural forces have been responsible for the lack of durable inflation in developed economies for decades, and those forces are still with us—hence, inflation won’t happen. What follows are some thoughts on each.
Pushback No. 1: Inflation is more or less impossible with labor market slack.
The economics textbook says that when the pool of untapped labor is large, upward price pressure is difficult to achieve because for every incremental unit of demand in an economy, there is an unemployed worker on the sidelines who can go back to work to produce the incremental unit of output to satisfy the demand; therefore, there is no change in the price level. This is inherently quite sensible.
However, during the COVID-19 lockdown, a peculiar thing happened. Unsurprisingly, the supply side of the economy contracted enormously. Millions of workers who produced output in prior years were rendered unemployed, and businesses that produced output and earned profits were fully or partially closed. Yet the demand side of the economy did not contract, because of the nature of the MMT-financed fiscal transfers. Most households received checks, which boosted income and savings, and on top of that, workers and firms whose ability to produce output was curtailed by COVID-19 had their income and profits replaced by federal unemployment programs and the Paycheck Protection Program grants, respectively. The enormous aggregate fiscal transfers into the economy succeeded in filling the income hole, and with respect to wealth, rather than income, frankly there wasn’t much of a hole to fill. In prior recessions, like the global financial crisis (GFC), the transfer payments that did occur were used to fill capital holes. In the GFC, the entire global real estate market dropped in value, destroying wealth, and in many cases the erosion of wealth was magnified by very thin equity cushions on assets that were leveraged with debt. This time around, with the COVID-19 recession, there was no such hole in the bottom of the proverbial bucket. Sure, some assets declined in value, but holistically, asset values in general (and aggregate wealth) have continued to increase apace.
So, wealth increased, demand was unchanged or higher, and supply dropped during 2020, leaving the economy supply-constrained despite the dramatic rise in labor market slack, which has not yet been fully worked off. That alone suggests to me that price pressures are building, and I think that the supply constraints will remain as the economy reopens. Importantly, supply constraints won’t be because the rehiring of workers and reopening of businesses will be slow—on the contrary, I think they will be very rapid. Rather, the supply constraint comes from an inability of the economy to meet the still-increasing demand side. Remember, another round of stimulus checks is going out right now, further bolstering the demand side of the economy, which never took a serious hit during 2020. If airfares and hotels are too expensive upon the reopening for broad-based uptake, then those checks will get spent elsewhere. I don’t envision anything getting cheaper in 2021 than it was in 2020, except maybe third-hand Aeron chairs, though I am going to hang on to mine!
Pushback No. 2: Offsetting movements under the surface of the inflation statistics will prevent an increase in aggregate inflation.
Even the Federal Reserve (Fed) is on board now in expecting a holistic rise in the price level in the economy on reopening. For a while, in recent months, the Fed pointed to base effects as driving expected, but only temporary, rises in the headline year-over-year inflation statistics as we come full circle from last year’s sudden economic stop. For those who follow the stats closely, the base effects are all but certain to drive up the inflation stats in the April–May time frame. However, there has been, to my ears, a subtle change in messaging out of the Fed, suggesting it now agrees that the economic burst on reopening is likely to drive up prices across the board beyond just the base effects, but importantly that that too will be a temporary artifact of the reopening, and not sustainable. This is the key point I want to try to refute. What I am anticipating is a potential wholesale change in consumer (and corporate) behavior in which consumption decisions are brought forward because of an expectation or concern that prices will be higher during the horizon of need. For example, if I know I’m going to need an item of clothing a month from now and I can afford it now, I buy it now because I think it could be more expensive in a month.
For decades, inflation statistical analysis in the U.S. has centered around supply and demand mismatches in the underlying components of the inflation consumption basket. So, for example, during periods of excess supply in housing, the shelter component would be projected to slow down in terms of price rise, and equivalently during periods of excess demand for, say, used cars, the used car price component of the basket would be expected to increase. Ultimately, the inflation level of the whole basket (or lack thereof) was a result of a multitude of offsetting supply-demand mismatches under the hood of the data. That was (and might remain) the right way to analyze it. What causes a sea change is the part about altered systematic consumer behavior: when consumers start to concern themselves not with the future availability of an item but the future price of an item. For now, this is my base case, and it could be the contemporaneous combination of reopening-related price hikes (which the Fed labels temporary), the base effects that may jack up the year-on-year core CPI stats to 3% or more and the rise in perceived purchasing power when a typical family of four receives a tax-free USD 5,600 check in the mail that has the potential to change behavior. I should also note that what I am describing anecdotally is exactly the same thing as a rise in the “inflation expectations” statistics that the Fed pays close attention to. Perhaps in the way I describe it, it is clearer why inflation expectations play a critical role in whether actual inflation is temporary or durable, and also that inflation is kind of circular. The Fed made clear in its average inflation targeting (AIT) framework that it did not want to see inflation expectations become unanchored from 2%, and I take it at its word on this. So if—a big if—I am correct about a potential change in consumer behavior, the Fed would respond and accelerate its exit from quantitative easing (QE) and zero interest rate policy. We need not worry about uncontrolled inflation in the U.S. because we still have an independent central bank, which has not completely ceded control of inflation to Congress in our era of MMT-like policy adoption. The interest rate markets, though, still have not fully adjusted to this potential endgame.
Pushback No. 3: Large debt overhangs are inherently deflationary.
Much of the dramatic increase in aggregate indebtedness, both in the U.S. and elsewhere, in 2020 was through increases in government debt, and the vast majority of the new government debt was purchased by the central bank of the issuing country. Though the sizes were large, this is, of course, not a new phenomenon, as it is the core outcome of both long-standing QE programs and the newer implementation of what I have called MMT-financed fiscal transfers. MMT disciples and sticklers point out to me that this is not true MMT, in part because of the existence of these bond purchases by central banks, rather than, say, the Treasury just printing money directly to “finance” its fiscal transfers.
Now, consider the possibility that the Fed will do two things forever: 1) it will refund the interest payments it receives from the Treasury back to the Treasury, and 2) it will “roll” the principal payments when they come due. If we take as a given that the Fed will do these things—always refund the interest and never force repayment of principal, always accepting a new bond instead—then in effect the Treasury debt held by the Fed is entirely composed, economically speaking, of zero-coupon perpetual bonds. A bond that pays no interest and has no maturity (a zero-coupon perpetual) is worth absolutely nothing. So, in a sense, the difference between true MMT and what I’ve perhaps sloppily labeled MMT is just semantics and technicalities.
However, in addressing the issue of why the debt overhang exacerbated by the massive 2020–21 fiscal stimulus is not deflationary this time, I need to acknowledge that the semantics have been important in the past. In Japan, while the government debt burden continues to grow, a higher and higher percentage of it is owed to the Bank of Japan (BOJ). It is a commonly held belief that Japan has a debt sustainability problem and that if interest rates were to rise materially, their interest costs alone would exceed the entire fiscal budget. This large and growing debt overhang has often been cited as a key cause of Japan’s deflationary and growth malaise. I would agree. However, the policy response so far by the BOJ has been to further the notion that the debt burden is unsustainable by implementing yield curve control (YCC), which effectively caps long-term government interest rates, and by persistent attempts to generate inflation and fiscal restraint at the same time by implementing things like consumption taxes. All of these actions, and hand-wringing about debt-to-GDP levels, perpetuate the semantics: Somehow the government of Japan owes a bunch of money to its central bank.
If Japan wanted to 1) generate honest-to-goodness inflation, and 2) reduce its debt burden, then simply canceling the bonds owned by the BOJ would probably do it. And what would the negative consequences be? The only one I can think of would be too much inflation. So, in a sense, the mere existence of these bonds and the perception that the money is owed to the central bank are a restraining force on inflation. What if the BOJ pledged to continue doing indefinitely what it has always done in the past—refund the interest and roll the principal? This would highlight what I think is the reality: Debt owed to a central bank in the currency controlled by the sovereign and printable by the central bank is sustainable at any size. Zero-coupon perpetuals are worth zero. In effect, this is an emperor-has-no-clothes moment. Funding giant fiscal transfer packages with IOUs to the central bank is not the same thing as forcing the country to forgo future consumption in exchange for current consumption. There is no reason taxes need to go up in the future to pay for these fiscal transfers happening now. When I say it like that, folks gasp and say, “Well, then we’d get inflation!” Of course we would, but everyone seems to want inflation, right? Debt overhangs between governments and central banks do not need to be a deflationary force as they have been in the past as long as there is a shift in the collective psychology around how that debt gets paid for in the future. As far as I can tell, it can be costless, if inflation is not considered a cost.
Pushback No. 4: Structural demographic and geopolitical forces have created an environment that is inherently deflationary, and those forces will prevent inflation from taking hold now, as before.
In a nutshell, the rise in labor supply from the decades-long development and quality-of-life increases in China and other similarly situated smaller countries has almost for sure overlaid the global economy with a deflationary blanket. That rise in labor supply has directly forced down wages across the world, so that’s deflationary, but also the declining real cost of output (due to lower labor costs) globally has at least slowed the pace of consumer price inflation, if not caused outright deflation. Additionally, the global economy has experienced a period of demographic evolution in which dependency ratios have been improving, meaning that the ratio of dependents to workers has been declining. To be blunt, workers are a deflationary force because they produce more than they consume, and dependents are an inflationary force because they consume much more than they produce. In recent decades, these demographic trends have been favorable for price stability.
Annoyingly, both of these dynamics—the excess labor supply and the improving dependency ratios—are imminently set to reverse, and in some countries it has started already. This entire process is discussed in detail in the 2020 book The Great Demographic Reversal, by Charles Goodhart and Manoj Pradhan. This book is a necessary read if you’re hopeful that demographics will be the anti-inflationary bailout that it has been in recent years. The authors make a compelling case to the contrary.