Inflation Is Uncontainable But Not Inevitable

Otherwise intelligent people can be surprisingly wrong about economics. The latest example is the claim that current inflationary pressures are somehow being “captured” or “locked up” in asset prices, and that those pressures may someday inflate the prices for goods and services.

On one hand, you can see why this view might seem plausible. The U.S. Federal Reserve engaged in an unprecedented monetary expansion in 2008 and 2009, increasing the total of bank reserves held at the Fed by trillions. More recently, on a year-to-year basis the broader measure of money supply, which also reflects private credit creation, increased by about 26%. Meanwhile, the major stock price indices rose to new heights during a disastrous pandemic, bond prices have remained high, and the total value of cryptocurrency topped $1 trillion, if only temporarily.

The hypothesis is that a lot of this new money got funneled into asset price markets, rather than being spent on goods and services. Measured rates of price inflation for consumer goods have remained stubbornly below 2%.

This view is misguided. First, dollars are not “trapped” in one sector of an economy, unable to be spent in other areas. If for instance equity prices are very high relative to food, people will sell equities and buy more food, or otherwise adjust and bring the prices back to proper levels. The experience of hyperinflation in Weimar Germany and Venezuela shows that it is not possible to keep price increases “bottled up” in particular sectors. They spread through the entire economy very quickly.

What about the theory that equities are a bubble, and that prevents people from cashing out? But equity prices, while strong, have been stable rather than exhilarating in recent times. Plenty of investors seem content to treat their equity holdings as normal investments rather than as vehicles for wild speculation.

More important, recent price-earnings ratios are only modestly above their historic values. That may be a reason to be cautious, but it is hardly a sign of suppressed inflation. Bond prices are high, but real interest rates have been falling for centuries. And the European Central Bank tends to pursue tighter monetary policy than does the Fed. Europe often has very low interest rates, including sometimes negative nominal rates.

To see why the huge increase in bank reserves did not result in inflation, consider that there has been a considerable decrease in U.S. excess bank reserves over the last five years. No one claims that this has been accompanied by a massive deflation, whether in securities markets or elsewhere. Once that point is conceded, it’s possible to see why higher levels of reserves are not necessarily inflationary.

The most coherent form of the inflationary hypothesis would that all the new money is going into crypto. But that doesn’t explain why just about all other prices in the economy seem — how to put it? — pretty normal. It is certainly possible that current crypto prices represent a bubble, but if so the Fed would not be the main culprit, given crypto’s rags-to-riches story.

It’s entirely conceivable, of course — even likely — that retail price inflation will increase in the near future, with the arrival of vaccinations, an economic rebound and the release of pent-up savings. But it is unlikely to be shockingly high, and the reason won’t be that financial-market funds are suddenly flowing into the consumer sector.

Whenever someone tells me that much higher rates of price inflation are imminent, I ask a simple yet obnoxious question: “Have you shorted the long bond?” High price inflation, of course, would be very bad for the value of long-term debt securities.

Although some investors have shorted Treasury bonds, those who fear these large inflationary pressures typically have not. It’s almost as if financial markets need something to be afraid of, and inflation is a convenient candidate. If investors really want something to worry about, they might want to look into the security of the U.S. banking system.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. His books include “Big Business: A Love Letter to an American Anti-Hero.”

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