Sunday, April 12, 2020
Even as we dive into recession, some worry about the return of inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt.

At this time, indeed at all times, I am conscious of not wanting to add to the mood of concern, to put new bricks in the wall of worry. But it would be remiss of me not to address something that some people are worried about, which is that this modern great plague that we are seeing will be followed by a great inflation.

I say worried. Some would say that for governments racking up a lot of additional debt in their efforts to fight the coronavirus and trying to limit its economic impact, higher inflation would be no bad thing. It was part of what became known as financial repression is the period after the Second World War, when inflation reduced the real value of debt and governments were able to borrow at negative real interest rates.

For most people, however, inflation is unwelcome, particularly when the outlook is for wage growth, in cash terms, to remain subdued, and for official interest rates, and those most savers can expect, to stay close to zero.

Should we be worried about inflation? There was a flurry of concern on Thursday when the Bank of England and the Treasury announced, in effect, that the Bank was increasing the government’s overdraft facility. The Ways and Means facility, normally around £400m, will be increased, as during the financial crisis, when it reached £19.9bn.

When people and businesses have to increase their overdraft facilities it usually shows that they are in trouble. The government is not in financial trouble, but it does need cash to finance the crisis measures it has announced, smoothing the amount it can raise by selling gilts (UK government bonds).

That is how the announcement should be seen, rather than the so-called monetary financing – the Bank directly funding government spending – that the new governor, Andrew Bailey, has publicly set his face against. When the Bank creates money, as it is doing by expanding its QE (quantitative easing) programme by £200bn, and purchasing gilts, it is ensuring that it is doing so via the market. The government, via the Debt Management Office, issues gilts into the market. The Bank buys gilts, not necessarily the same ones, from the market. People may think this is convoluted, but it keeps things honest.

Despite this, some fear that the combination of ultra-low interest rates and other central bank measures, including QE, together with an explosion in budget deficits, is sending a big inflation warning signal.

Tim Congdon, once economics correspondent of The Times, then a much-followed City economist, now chairman of the Institute if International Monetary Research (IIMR) at the University of Buckingham, has had a commendably consistent view since the 1970s, when he helped shift economic policy towards monetarism.
He believes that the key to the outlook for inflation is the growth of the broad money supply, M4 I the UK, and one follows the other as sure as night follows day.
As he put in an IIMR note a few days ago, referring to the new governor: “Bailey needs to be told – like his predecessors – that the rate of increase in the UK price level depends on the rate of increase in the quantity of money relative to the rate of increase in the quantity of goods and services.”

Congdon’s particular worry at the moment is America where, he says, as a result of the exceptional measures being taken, this year may see the biggest increase in the broadly-defined quantity of money in peacetime. He does not blame the authorities for taking exceptional action, because they could not obstruct governments wanting to save lives. But: “The policy response to the coronavirus pandemic will be followed by an inflationary boom.”

In Britain, meanwhile, he foresees an inflation rate “closer to 10% than we have seen for many years”. The many years thing is correct; on the current measure of consumer price inflation, inflation has not been in double figures for more than three decades.

He is not the only one to be concerned about monetary trends. David Owen, an economist with Jefferies International, the investment bank, expects UK broad money growth to be 10% or more by the end of the year.

Michael Howell, who runs CrossBorder Capital, a consultancy, warns of “an inflation tsunami”. As he puts it: “The huge monetization of deficits planned by Central Banks, culminating in a one-third jump in the size of their balance sheets, could lead to 15-20% monetary growth in 2020. With velocity already depressed and real GDP growth slow, this surely must lead to faster inflation of circa 5-10% in the US from 2021. Bonds beware.”

How worried should we be about moving into an era of high inflation or what Congdon describes, more benignly, as a one-off shock to the price level – higher prices – as coronavirus measures wash through the system? He is right to say that broad money growth, and concerns about inflation, are secondary at present.
Is inflation on the way? Many will remember high-profile warnings about inflation in 2008-9, when central banks launched their QE programmes. And, while inflation in Britain rose to more than 5% in 2011, some of that was due to George Osborne’s hike in VAT from 17.5% to 20%. Inflation soon subsided.

The money created by central banks then replaced that destroyed by the crisis and the damage to the financial system but did not result in exceptional money supply growth. The annual growth in M4 has averaged 3.9% over the past 10 years and is only a little above that now.

This time may be different, in that after the crisis banks were being encouraged to rebuild capital, while they are now being encouraged to lend. But there are other forces that will bear down on inflation. UK inflation is currently below the 2% official target and set to fall further when new figures are released in 10 days’ time. The short-term drivers of inflation, including the oil price, and thus the price of petrol, which nobody is much buying, are sharply down.

Five years ago, in 2015, consumer price inflation averaged zero, its lowest since the early 1960s, and there were some months in which the annual rate was negative; statistical deflation. It will not be entirely surprising, with the lockdown enforcing a sharp drop in demand, if we see a repeat of that in coming months.
Beyond that, it depends. In both Britain and America we are seeing a sharp rise in unemployment; probably towards 10% in Britain and towards Great Depression levels in America. It would be a super-stagflation indeed if, alongside that, we were to see the rapid emergence of high inflation.

Beyond that, and beyond the immediate crisis and the return to some kind of normality, however, there is a debate to be had. Part of it arises from crisis measures, and the big boost to money supply growth they threaten. But it could also arise from the combination of a rapid, post-crisis rebound in the economy, alongside supply shortages as international borders only gradually open. We do not need to worry about inflation for some time. We may have to worry eventually.