Tuesday 17 Jul 2018 | 18:02 | SYDNEY
Tuesday 17 Jul 2018 | 18:02 | SYDNEY

Great Recession, then Great Inflation?


Mark Thirlwell

4 June 2009 17:09

The bond market vigilantes are back, and they’re worried about inflation. (Although see Menzie Chinn for some perspective.) Germany’s Chancellor, Angela Merkel, is worried too, recently expressing her alarm at policies being pursued by the Fed and the Bank of England, and even by the more cautious ECB. China, meanwhile, is nervous about the value of its US investments and is expressing doubts about the future of the greenback. And Ben Bernanke is taking the bond markets’ jitters to heart and is stressing the need to manage long-term fiscal sustainability. 

Do burgeoning levels of public debt and quantitative easing by central banks herald an inflationary future?

At first – and actually at second – glance, worrying about inflation right now seems pretty strange. After all, haven’t we just seen dramatic falls in activity across much of the developed world (at least, outside Australia)? Remember, the US economy shrank at an almost 6% annual rate in the first quarter to help deliver its worst six-month performance in half a century; Japan’s Q1 GDP plummeted at an annual rate of 15.2%, setting a new record; and in Germany, first quarter GDP dropped at an annualised rate of 14.4%. The collapse in economic activity means that estimated output gaps are now large and negative in the US, Japan and most other developed economies:  

Source: IMF World Economic Outlook Chapter 1.

So you might think that deflation rather than inflation is the more important risk. Yet over the past couple of months, several economic heavyweights have fretted about the dangers of inflationary pressures. For example, in May, Allan Meltzer, writing in the NYT, worried that a Fed policy rate set at close to zero, large increases in bank reserves, and the debt that will be generated by  ballooning fiscal deficits all threatened a return to rising inflation in the US. Similarly, Martin Feldstein’s April piece in the Financial Times warned that ‘(t)he unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation.’ More recently, and in the same newspaper, John Tayor has cautioned about the consequences of the growing US debt burden.

So what’s going on? One possibility is that the inflation pessimists just don’t buy the message that comes from output gap analysis: see for example this column by Bloomberg’s Caroline Baum. Or they might think that the world works differently now: Simon Johnson notes that while policymakers in the US treat talk of an imminent inflation risk with ‘derision’, it is at least possible that there has been a change to inflation dynamics.

Paul Krugman, in a resolutely sceptical look at the current inflation scare, provides two other alternatives. First, that ‘in weird times like the present, when many of the normal rules no longer apply’, it is even more likely than usual that economists will disagree strongly about where the economy is going. And second, that ‘the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.’ 

I think a useful way to think about this issue is in terms of different time horizons. In the near-term (and absent some sort of dramatic V-shaped global recovery) the presence of large output gaps indicates that the risks remain tilted firmly towards deflation rather than inflation for most of the developed world. But take a longer-term perspective, and it makes sense to be thinking more about inflation. In part, this is because there is actually a reasonable case to be made that a dose of moderate inflation would be helpful for some countries. 

It’s also because of the damage that the GFC has inflicted on our current monetary policy arrangements. In particular, the credibility of central banks in the US and UK has taken a severe beating, and partly as a result, the previous trajectory of relative independence from government can no longer be taken for granted. (Even Merkel’s outburst can be seen as evidence of a sort for this proposition, although she is certainly not calling for a more inflation-friendly central bank.) Combine that with large projected increases in public debt and its not at all surprising to me that a potential resurgence of inflation appears in several plausible future scenarios. 

That’s not to say it’s inevitable, however. As Krugman, Chinn and others have pointed out, Japan’s experience stands as a case-study of a country that managed to combine large increases in public debt, big budget deficits, and quantitative easing with no surge in inflation, let alone the hyperinflation that opponents of non-traditional monetary policy worried about back then – and worry about in the US now.