The country is under watch for whether its huge monetary and fiscal loosening will spark inflation
As the impact of the pandemic recedes in the United States, money supply growth is sharply increasing, commodity prices are rising, and government spending is surging. The combination of these things has meant the rise of inflation fears and markets have been in the grip of a ‘taper scare’ for several weeks now. Cryptocurrencies have emerged as the hedging commodity of choice.
Last March, as the pandemic began, the US Federal Reserve lowered its Fed funds target rate to between 0% and 0.25%. It restarted its quantitative easing (QE) programme and expanded QE purchases to an unlimited amount. The Fed’s balance sheet has grown from about $4 trillion right before the pandemic’s onset to about $7.9 trillion as of last week. For context, the Fed’s balance sheet rose by about $3 trillion from $1 trillion over a five-year period after the global financial crisis (GFC) in 2008. US M2 money supply has grown by a seasonally-adjusted annual rate of over 20% for nearly a year (it moderated slightly to 18% in April 2021). To help small businesses, in concert with the CARES Act, the Fed launched a programme to lend money to banks so that they can, in turn, on-lend it to small businesses through the Paycheck Protection Program. There is no current limit to the amount of credit that can be extended through that programme, though it will end by 30 June.
As some of the Fed’s programmes have wound down, government fiscal spending has risen in the US. Newly-elected President Joe Biden passed the fifth major US fiscal programme of $1.9 trillion in March 2021 on top of the approximately $3.5 trillion in packages that had already been implemented. Biden has announced a large and ambitious $6 trillion budget over the next 10 years for recovery and growth. Only $3.6 trillion of Biden’s proposal would be paid for by new revenues (increased corporate tax, taxes on capital gains); the net deficit will increase by about $1.4 trillion by 2030. The exact size and details of the package may undergo change as it winds its way through Congress, but Biden’s proposal will increase the country’s debt to 117% of gross domestic product (GDP) by 2030, which would be the highest after World War II.
This combination of monetary and fiscal stimulus is unprecedented in global economic history. Economic theory would have it that when subject to this level of stimulus, demand would rise, and if supply is unable to keep pace, prices would rise as well. Reflecting this uncertainty, US long-term yields measured by the 10-year Treasury Bond have risen from under 1% to 1.6% now. Many analysts believe that if this yield were to rise beyond 2%, funding the extra deficit would become problematic in terms of increased cost. Some believe that the Fed would have to signal (and possibly act on) a ‘cap’ on long-term rates above 2%, let the dollar fall significantly, or both. There is pressure on the dollar to decline anyway because it has an (expanding) negative real yield. A declining dollar risks importing inflation from recovering international economies. For a variety of reasons, it seems unlikely that the Fed will go about trying to peg long-term interest rates. This is unlikely to succeed and may deliver unintended consequences. Nevertheless, it’s very likely that the magnitude of Biden’s proposed extra deficit will create inflationary pressures in coming years.
There are mitigating factors. Central banks have broken the back of inflation and built credibility over the last three decades. Despite the large central bank balance sheet expansions in the US after the GFC and Japan over the last 30 years, inflation has not become worrisome. Both the knowledge and tool kits of central banks have improved materially in recent decades, and some comfort can be drawn from the ability of central banks to navigate a balanced path. Additionally, a good chunk of Biden’s budget proposal is targeted at building productive assets: preparing America for a green future and rebuilding its infrastructure. Investing in assets with an economic multiplier typically does not cause inflation. In the longer term, it may even help reduce inflation.
For the immediate future, the output gap in the US economy has not closed and unemployment is still over 6% (versus the pre-pandemic low of 3.5%). While bond yields and inflation expectations have risen, inflation remains well under the threshold of 2% that the Fed likes to see. The Fed signalled a shift in its thinking when it said it would hold interest rates lower for longer, waiting to see actual inflation numbers over 2%, rather than react to inflation expectations. For all these reasons, the taper scare of this summer will recede even as the US economy regains its full strength this year. Unemployment will gradually come down and the country’s output gap will shrink. Whether the stimulus cocktail will lead to runaway inflation in the long-term, only time will tell. We may be headed for the 1970s, but I doubt we’ll get there. For the moment, I am sanguine.
P.S: “Inflation is always and everywhere a monetary phenomenon," said Milton Friedman. My addendum: “If you remove hyperinflationary episodes, the money supply link to inflation is moderate."
This is the first of a two-part series on the post-pandemic global macro-economy. The next column will focus on the impact of US economic conditions on China and emerging markets.