Inflation now a fiscal phenomenon

Changes to spending patterns obscure near-term outlook

Money and credit numbers have gone haywire in recent weeks as households have stopped spending and companies have borrowed heavily to shore up their cash balances.

The sudden spike in corporate borrowing has led to a rapid increase in broad money. This is most extreme in the US (see Figure 1), where corporate borrowing from money market funds and commercial banks is climbing at a rapid rate. The M2 money supply measure is gaining 20% year-on-year. M3, a broader measure of money no longer published by the Federal Reserve but which is a better indicator of demand, is estimated to grow by 12% annually.

Figures 2 and 3 show similar trends in the UK and euro area – heavy borrowing by corporates fuelling money supply expansion. But this is likely to be temporary. Corporates are relying on short-term financing to see them through the next few months and many will have limited borrowing capacity. They will be borrowing heavily to stay afloat as sales dry up and to shore up their cash balances in case lending conditions are less savoury down the line.

Additionally, the housing market has frozen in many economies, so lending to the private sector may flatten out over coming months; mortgages tend to be the largest component of bank lending to the private sector for most advanced economies, far larger than loans to businesses.

While the private sector’s sudden borrowing binge may prove short-lived, the public sector’s will not. Accounting for government borrowing, Tim Congdon, chairman of the Institute for International Monetary Research, estimates US M3 growth could reach 15%-20%, euro area M3 growth 7.5%-12.5%, and UK M4x 7.5%-15%. Congdon forecasts higher inflation going into 2021. These are subject to the usual caveats of economic forecasting, but they illustrate the scale of measures taken and would be some of the highest rates of money growth since the 1970s, when inflation reached double-digits in many advanced economies. Even if the private sector’s borrowing is momentary, government deficits will propel money growth.

One of the caveats will relate to demand by the private sector to hold money. Much of the increase in money growth over March and April was due to the private sector wanting to increase its cash balance. The demand for money rose and the supply increase matched it. Higher money demand will last as long as the crisis. How much the government is prepared to borrow is another consideration. An advisory policy document leaked to the UK’s Daily Telegraph on 12 May referred to a plan to raise taxes and cut spending, but the document also said the ‘timing, pace and composition of any consolidation should be managed carefully to avoid the risk of stifling the economic recovery’. On balance, finance ministries and treasuries have an inflationary bias, a reversal of the attitude held for most of the 2010s, but this will be something to keep an eye on, as well as the money numbers.

The implication of more money is higher inflation, but that is not necessarily a bad thing. A bit of inflation, if temporary and demand-led, helps the private and public sector to deleverage so they can spend more on consumption and investment rather than servicing debts. If inflation is demand-led it need not reduce savings and income, as rising income will be the cause of inflation, and savings will benefit from higher asset prices and interest rates.

These factors will determine inflation later in the year. Changes to spending patterns obscure the near-term outlook. As Silvana Tenreyro, an external member of the Bank of England’s monetary policy committee, said in a speech last month, ‘While Covid-19 is still widespread and with current social distancing measures in place, consumer price index inflation is not going to be as informative as usual about the balance of supply and demand in the economy. This is because of the conceptual challenges that will affect price measurement during the current crisis.’

Tenreyro reckons the medium-term outlook is likely to be more deflationary, but stresses the high level of uncertainty. Since that speech, the collapse of oil prices has added considerable weight to the deflationary argument, but the impact of oil prices only last 12-18 months, after which the effects of one-off price changes on price indices begin to filter out. By that time, fiscal policy will probably be playing a role in aggregate demand and inflation that it hasn’t played since the 1970s.

Chris Papadopoullos is Economist at OMFIF.

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