Why inflation may buck the forecasts and make a comeback
- Today’s economic conditions have no precedent in the past 50 years, so the current forecasts are no guarantee that inflation will actually remain low
- The huge fiscal and monetary expansion in response to Covid-19 may pose an even greater inflation risk
Economic models have long been notoriously inaccurate in predicting inflation, and Covid-19 has further complicated the challenge. While economic forecasters calibrate their models using data from the past 50 years to explain and predict economic trends, today’s economic conditions have no precedent in that period. Today’s low inflation forecasts are thus no guarantee that inflation will actually remain low.
Even without additional inflationary pressure, reported inflation rates will rise significantly in the first five months of 2021. By May, some forecasts expect year-on-year inflation to rise above 2 per cent in the United States and towards 2 per cent in the euro zone, largely owing to the low base in the first half of 2020, when pandemic-related lockdowns began.
The higher rate therefore does not point to rising inflationary pressure, though an increase above those levels would be a warning sign.
But a detailed look at supply and demand reveals a more nuanced picture. In particular, the pandemic has shifted demand from services to goods, some of which have become more expensive, owing to production and transport bottlenecks.
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Previous episodes of excessive government debt almost always ended with high inflation. Inflation caused by a loss of confidence can emerge quickly and in some cases at a time of underemployment, without a preceding wage-price spiral.
Although expansionary monetary policy after the 2008 global financial crisis did not lead to increasing inflation, this is no guarantee that price growth will remain low this time. After 2008, newly created liquidity flowed mainly into financial markets.
But central banks’ current balance-sheet expansion is triggering large money flows into the real economy, through record fiscal deficits and rapid credit growth in many countries. Moreover, the monetary policy response to the pandemic was much faster and more substantial than in the last crisis.
A sharp rise in inflation could have devastating consequences. To contain it, central banks would have to raise interest rates, which would create financing problems for highly indebted governments, firms and households.
Historically, central banks have mostly been unable to resist government pressure for sustained budget financing. This has often resulted in very high rates of inflation, accompanied by large losses in the real value of most asset classes and political and social upheaval.
Too many are underestimating the risk of a rise in inflation, and sanguine model-based forecasts do nothing to alleviate my fears. Monetary and fiscal policymakers, as well as savers and investors, should not allow themselves to be caught out.
In 2014, former Fed chair Alan Greenspan predicted that inflation would eventually have to rise, calling the Fed’s balance sheet “a pile of tinder”. The pandemic could well be the lightning strike that ignites it.
Axel A. Weber, a former president of the Deutsche Bundesbank and former member of the Governing Council of the European Central Bank, is chairman of the board of directors of UBS Group AG. Copyright: Project Syndicate