Is Inflation Coming?

For more than a generation, the U.S. inflation-targeting framework has delivered impressive results. From 1995 to 2007, U.S. inflation averaged 2.1% (as measured by the Federal Reserve’s preferred index). Since 2008, average inflation dropped to only 1.5%, but expectations have fluctuated in a narrow range: for example, the market-based five-year, five-year forward (CPI) inflation expectation rarely dipped below 1.5% and never exceeded 3%.

However, the pandemic brought with it many dramatic changes. Fiscal and monetary policy mobilized, responding swiftly to the economic plunge with a combination of extraordinary debt-financed expenditure and balance sheet expansion. As a matter of accounting and arithmetic, these actions have had a profound impact on the balance sheets of banks and households, spurring dramatic growth in traditional monetary aggregates. From the end of February to the end of May 2020, broad money (M2) grew from $15.5 trillion to $17.9 trillion—a 16% jump in just three months.

Won’t the record 2020 gain in M2 be highly inflationary? We doubt it, and in this post we explain why. At the same time, we highlight the chronic uncertainty that plagues inflation. In our view, the difficulty in forecasting inflation makes it important that the Fed routinely communicate how it will react to inflation surprises—even when, as now, policymakers wish to promote extremely accommodative financial conditions….

Inflation is not (and should not be) a key worry today

A very simple version of 1960s monetarism has two elements. First, controlling money growth is necessary and sufficient to control inflation. Second, leaving aside a financial crisis, the monetary base―the sum of currency in circulation and commercial bank deposits at the central bank―determines the quantity of money. Putting those together means that, in order to control inflation, all central bankers need to do is ensure that their liabilities grow at the appropriate rate. Conversely, when the central bank’s balance sheet grows quickly, inflation inevitably follows.

This simple monetarist reasoning was still on display in 2010, when Ben Bernanke received this letter from a group of 24 economists warning against further large-scale asset purchases by the Fed. At that stage, the central bank’s assets exceeded 250% of their level in September 2008. Over just over two years, the Fed had purchased roughly $400 billion in Treasury securities and $1 trillion in federally guaranteed mortgage-backed securities. But, as Bernanke explained at the time, the purpose of these asset purchases was to aid the economy in recovering from the crisis-induced recession. Moreover, in contrast to prior norms, since October 2008 the Fed had been paying interest on reserves, raising the opportunity cost for banks to lend.

Subsequent experience proved the letter writers very wrong. The Fed’s balance sheet continued to grow, peaking at $4.5 trillion in early 2015. And, over the decade just ended, inflation (measured by the Fed’s preferred consumption expenditures price index) averaged 1.6%―below the central bank’s long-run goal of 2%. If anything, in recent years, and despite massive central bank balance sheet expansions, inflation both in the United States and in other advanced economies has been too low, not too high.

With central bank balance sheets now surging again, we recount this history in the hopes of blunting any inflation concerns, which we see as profoundly misguided. Over the six weeks ending April 22, the Fed’s assets have grown by the same amount as they did from September 2008 to March 2013. While this does raise some serious concerns, inflation is not high among them….

Commentary

Money, Banking, and Financial Markets