Fear of inflation is not grounded in facts
A high rate may be a risk in the very long run – but right now the risk is that it may be too low
Milton Friedman, recipient of the 1976 Nobel Prize for economic science.
Almost three years ago, at the World Economic Forum’s “Summer Davos”, in Tianjin, I heard a Republican politician say that the US would be in hyperinflation within two years. I was stunned. Yet a large number of people believe that hyperinflation is coming. If the US is in trouble, so, surely, is the UK. Is there anything in such predictions? The answer is: possibly, in the very long run. At present, however, the risk is that inflation may be too low, not too high. Paradoxically, that increases inflation risk in the long run.
What drives an inflationary process? The late Milton Friedman gave the classic answer: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
But this does not explain why the quantity of money should grow more rapidly than output. The answer of those now terrified of inflation is twofold. First, central banks are “printing money” through “quantitative easing”, which will ultimately produce an explosive rise in broad money. Second, prospective levels of public debt will ultimately encourage governments to default, via inflation.
Let us look at this big issue for the UK, which has rising public debt and relatively high recent inflation.
Whatever the longer-term dangers, the picture for the next two years or so is quite the opposite. Both core and headline inflation rates are reasonably low. Wage inflation is close to zero and, despite falling productivity, unit labour costs are rising at below 2 per cent a year. The exchange rate has stabilised, as have commodity prices. The International Monetary Fund forecasts that they are likely to fall in the next few years. On balance, then, short-term inflationary pressures are very weak. What is true for the UK is even truer of the US and the euro zone.
Now turn to the next five years. Over that period, demand and capacity utilisation will become important. Alas, UK gross domestic product is 16 per cent below its pre-crisis trend.
Official estimates also indicate much excess capacity: the IMF estimates the “output gap” – the difference between actual and potential output – at 4 per cent of the latter this year. Though not as high as one might expect, unemployment is at about 8 per cent.
Furthermore, the expansion of the central bank’s own balance sheet has not offset the declining willingness of the banks to lend. As a consequence, the amount of credit and so-called “broad money” in circulation is shrinking. Finally, fiscal policy is highly contractionary.
Even over the medium term, then, it is hard to believe inflation is more than a will-o’-the-wisp. So what about the longer term? Could the 2020s see an inflationary upsurge? Many believe so because there is a direct link – the so-called “money multiplier” – between the reserves of commercial banks held at the central bank and the lending by commercial banks to the public.
They assume banks will lend more against these reserves, meaning that the current high level of reserves at the central bank is an indicator of future monetary expansion.
But a solvent bank can obtain the reserves it needs from the central bank. Moreover, the central bank will make sure that such a bank never falls short of reserves, since the alternative could well be a breakdown of the payment system.