#77 The Inflation Conundrum 🎧
This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?
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The Trump administration is negotiating another stimulus package with Democrats that could be upwards of US$ 1.8 trillion. The Federal Reserve’s balance sheet continues to expand since the beginning of the pandemic. There’s a possibility it could touch US$ 10 trillion by the end of the year as it buys up treasuries, corporate bonds, mortgage-backed securities and muni bonds. With all this liquidity in the system and money in the hands of the average American, the macroeconomic puzzle is: where is the promised inflation? And if there’s no rise in inflation after such a dramatic increase in the deficit, why should the US bother about financial prudence? Why not just print money and spend your way to growth and prosperity?
The Indian Case
This has some resonance for India too. The loose monetary and fiscal policy regime we ran for longer than necessary after the global financial crisis (GFC) leading to high inflation in 2012-14 still casts a long shadow. That experience led to the flexible inflation target (FIT) that was set by the government for the Monetary Policy Committee (MPC) of the RBI. The results of the FIT regime have been mixed. It had become clear a couple of quarters before the pandemic began that this policy needed a relook. Growth had slowed down to a 4-5 per cent range while inflation remained at 4 per cent in the second half of last FY. But members of MPC-1 (whose term ended in September 2020) paused on rate cuts for the fear of inflation going beyond 6 per cent bound. Even at the peak of demand destruction in August, the MPC-1 had taken a hawkish stance on inflation that had the bond market worried.
The slew of measures announced by the RBI last week to keep the liquidity high in the system and to improve transmission from banks to borrowers to spur growth coupled with the commentary from the newly formed MPC-2, suggested it is willing to look past inflation running above 6 per cent. This came as a relief to the bond market as yields fell and spreads narrowed. The inflation question for India is relevant too. Will the quantitative easing done so far by RBI and its promise to continue to do more lead to higher inflation?
What To Make Of Inflation?
At the heart of these questions is whether the Friedman doctrine on inflation that has guided the actions of central banks for the better part of the last four decades still valid. He wrote:
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
The experience in the decade since the global financial crisis (GFC) doesn’t seem to bear Friedman out. Inflation has remained persistently low despite multiple rounds of quantitative easing by the Fed. There are structural reasons including a change in demographic composition, technological progress and innovation, productivity increases and global trade that account for this. This low inflation period in the developed world has meant there is a significant change in inflation expectations because of quantitative easing measures this time around. How do we know this?
Let’s look at the US 10-year yield movements over the past decade. In the aftermath of the GFC between 2009-13, on all occasions when the Fed pulled the QE lever (QE1, 2 and 3), the yields rose sharply on its announcement and fell when it ended. This showed there was a strong expectation of future inflation which led to people switching to short-term bonds from the longer ones. The pandemic related QE hasn’t seen this though. So far in 2020, the QE announcements by the Fed have hardly moved the needle on bond yields.
People no longer believe a loose monetary policy will lead to future inflation.
Central Banks’ Actions During The Pandemic
However, there is one significant difference in stimulus this time around. During the GFC, there was no significant fiscal stimulus provided by the US Treasury. It was a financial crisis, not a broader economic one. And it was solved by pumping more liquidity into the system. This time the quantum of fiscal stimulus to prevent destruction of demand has been enormous. Once the economy recovers and demand comes back organically, this extra money supply in the system will lead to future inflation. To what extent and when is still unknown. But the Fed is willing to have that kind of ‘heating’ up of the economy to support growth. And it doesn’t want to be forced to act when that happens. That’s the reason it moved to an average inflation targeting regime last month to give itself greater manoeuverability to take steps that could push inflation beyond the target of 2 per cent. It also signalled its intention of not raising the almost zero-bound interest rates anytime soon even if the inflation crosses 2 per cent.
In India too the message seems to be similar. We haven’t had a fiscal stimulus to match that of the US. But the RBI wants to signal it is willing to live with inflation running above ‘comfortable’ level in the coming days. The MPC report last week claimed almost 80 per cent of the increase in inflation beyond the 4 per cent target can be attributed to supply chain disruptions and increase in fuel prices. This it believes is a short-term phenomenon and inflation will be in the 5 per cent range next year. This is underlined to give comfort to bond investors to buy government securities without the fear of a near-term interest rate hike to contain inflation. Further, the other step announced by RBI in extending the HTM (hold-to-maturity) limits by another year to March 2022 is to protect any bondholder from the volatility of prices and booking losses on account of it. The overall RBI signal is it doesn’t want the worry of rising inflation and a consequent rate increase to come in the way of growth. It’s focus now is on improving the transmission of rate cuts to the borrowers to stimulate growth.
All of these point to two distinct shifts in thinking in monetary policymaking in both US and India. One, mere monetary expansion isn’t sufficient to trigger high inflation. Two, central banks are looking beyond price stability to include nominal GDP growth, currency management and employment as their objectives. This will be tough to manage but it is a more realistic set of goals to pursue in the current environment.
Reading and listening recommendations on public policy matters
[Article] Why is Inflation so low? by Juan Sanchez and Hee Sung Kim published by the Federal Reserve Bank of St. Louis.