Why the inflation scare will fade
Loose monetary policy sent inflation soaring. A looming crunch will bring it down equally fast, says Max King
The front cover of The Economist on 23 April showed a picture of Benjamin Franklin with his hand covering half his face in horror, topped with the headline “The Fed that failed”. So it seems. The US Federal Reserve’s preferred measure of inflation – the personal consumption expenditures (PCE) price index – has surged to 6.6%. On the consumer price index (CPI) measure, inflation has hit 8.5%. The comparable UK number is 9%, but expected to go higher, while inflation in the eurozone is running at 7.5%.
Yet long-term followers of The Economist’s covers know that it has a reputation as one of the world’s most reliable contrary indicators. Is it time to wonder if the inflation panic, far from becoming embedded, is peaking and will soon fade rapidly?
Forgetting the lesson of monetarism
“Inflation is like toothpaste,” Karl Otto Pöhl, the head of the Bundesbank in the early 1980s, said at the time. “Once it is out of the tube, you can hardly get it back in again.” But for the last 30 years, the annual rate of UK inflation oscillated around 2%, never rising above 5%. Consequently, the monetarists who dominated economic thinking 40 or 50 years ago have gradually been forgotten. “Inflation is always and everywhere a monetary phenomenon,” said Milton Friedman. Or “inflation is an increase in the quantity of money without a corresponding increase in the demand for it”, as Ludwig von Mises put it.
Yet “in the pandemic, we paid people to stay at home – a classic recipe for inflation”, says Chris Watling of Longview Economics. Monetary growth in 2020 had been the highest since 1943. That’s why monetarist guru Tim Congdon, the founder of Lombard Street Research and now the founder and chairman of the Institute of International Monetary Research at the University of Buckingham, was warning last autumn that “a rate of inflation of between 5% and 10% is to be expected in the US until the end of 2022, owing to a monetary overhang from the almost 35% growth in the two years to mid 2021. That surely stretches the notion of transitory.”
Today, there is a widespread view that higher inflation is a global phenomenon, says Watling. However, Japan is seeing continuing deflation while the annual rate of Chinese inflation is 1.5%. While broad money growth in the US accelerated by 24.7% in the two years to mid 2021, by 15.8% in the UK and 9.1% in the eurozone, the acceleration in Japan, China and India was much less. This is no coincidence.
“Of course, pandemics and wars always cause inflation,” adds Watling, as a result of supply-side shocks. However, it was the monetary policies of Western central banks that caused this to spill over into general inflation. This is being exacerbated at present by tight labour markets, which are leading to wage rises. In the 1970s, a wage-price spiral followed until tight monetary policies caused a recession.
However, monetary data suggests that a crunch is under way. US monetary growth has slowed on a three-month annualised basis to 3%, points out research firm Macrostrategy. Just two months earlier, the rate had been 6.2% and 5.4% in the eurozone, 3.8% in Japan and 2.2% in the UK.
We’re likely to avoid recession
“Overheating and upward pressures on underlying inflation will persist for a few quarters yet, but then inflation will exceed monetary growth. Asset price weakness is then almost certain as a precursor and associate of recession,” says Congdon.
“The recent moderation in money growth implies that inflation will come down closer to the norms of the 2010s… but the lags are such that both this year and 2023 will feature annual inflation rates typically above 5% and sometimes above 10%.” Growth in bank credit in the US will require the Federal Reserve to go on raising rates, but this is more muted in Japan and the eurozone, while regulatory pressure in the UK to raise the capital ratios of banks will be deflationary.
Watling is not convinced by the argument that we will see recession in the UK, thanks to £200bn of excess savings. He agrees that “inflation will come down in the medium to long term from where it was” but is optimistic that the supply and demand for energy will come into better balance in 2023, with high prices curtailing demand, stimulating output and causing prices to drop. If he is correct, inflation will come down sooner and faster than expected.
Real monetary growth might not turn negative, so economic growth in the West would still slow but recession would be avoided. In either scenario, interest rates have further to rise but should remain below 3%. This might mean that US government bond yields, which recently approached 3%, are near a mediumterm peak. However, Watling warns about longterm complacency. He believes that a 30- to 40-year downtrend in bond yields came to an end in 2020 and that the trend will be upward for equally long.
The outlook for equities depends on whether recession will be avoided. However, the behaviour of energy prices – with the oil price hovering around $100 a barrel rather than hitting new peaks – suggests that Watling will be proved right and The Economist, once again, will have got it wrong.
“US monetary growth has slowed from 6.2% to 3% in two months”