Economy & Markets

2021-01-07 Donato Masciandaro

Inflation: A Premature Funeral?

Is it time to celebrate the funeral of inflation? Hawks and doves have already begun to bicker over this question. And it is easy to predict that the debate will grow, especially if monetary policy, in both the United States and Europe, maintains an ultra-expansive attitude. Who is right? And who are the financial markets rooting for?

Has the time come to celebrate the funeral of inflation and think that monetary and fiscal policy must deal exclusively with economic growth and employment? The debate is not only underway, but also lively: on the one side, the doves, ready with the requiem; on the other, the hawks, ready to swear to the resurrection. What arguments does each side have? Let us start with what we know.

Economic analysis tells us in general that a pandemic recession can have both deflationary and inflationary effects. In fact, it all comes from a non-economic shock, in which the unpredictable event (the outbreak of the pandemic) is interwoven with the reaction of public health policies (the imposition of social distancing). The mix between disease and health policies thus ends up simultaneously affecting both supply and aggregate demand. On the supply side, the ability of businesses to produce goods and services is undermined by the health risk that can affect workers, and by that linked to blockages and delays in trade and procurement. To summarize, the pandemic shock to supply can be considered similar to an increase of costs, that produces a drop in production and an upward tightening of prices. Thus, the hawks say, a pandemic recession tends to push prices upwards, although not necessarily immediately. Not at all, respond the doves. On the demand side, a pandemic shock reduces both the capacity and the desire of families and businesses to consume and invest; as a result, the effect on prices is actually to push them downwards. Who is right? Let us look at the data, is the usual response.

Yet this time, looking at the data does not help close the debate, because the historical empirical evidence available gives us conflicting results: empirical works on the Spanish Flu of 1918-1920 associate inflationary phenomena with the pandemic, while the analyses of the pandemic recession currently underway show the exact opposite. We should not be surprised: the pandemic recession also has additional characteristics that are making its macroeconomic effects particularly unpredictable. One of these is in fact uncertainty.

The effect of uncertainty on price dynamics is also ambiguous, though. When uncertainty increases, in general businesses wish to defend their profit margins, because each business expects that others will do the same. But in turn, the ability of each business to defend its margins will depend on its market power, both as a seller of products and as a buyer of raw materials or intermediate inputs. The more the business acts in competitive markets, the less it will succeed in transferring the cost of uncertainty to consumers, or suppliers. Moreover: is uncertainty measurable, although in probabilistic terms – as the hawks tend to argue – or is it absolutely unpredictable – a perspective more common among doves?

Then there is the channel of expectations: anticipating price rises or falls tomorrow influences prices today. Yet if the dominant characteristic of the pandemic recession is indeed its special nature and the trait of uncertainty, then the mechanisms of expectations risks becoming a catalyzer of ambiguity, certainly not an anchor of certainty. Lastly, hawks and doves quarrel over the effect that ultra-expansive policies will have on prices. The hawks trot out numbers such as the following. Let us take the case of the United States. From February to September, the Fed increased the stock of dollars by almost 42 percent. Until now, the increase of currency has not been reflected in prices because uncertainty produces a rise in the risk aversion of families, businesses, and banks; the overall increase of liquidity has been less than half of that number, reaching only 21 percent. But the absence of a flare-up of inflation is only temporary. As soon as the pandemic recession ends, the risk of inflation will soar. Definitely not the funeral of inflation. 

The doves don't agree in this case either, offering other data. They go back to what happened in the relationship between monetary policy and inflation during the Great Recession of 2008. Between September 2008 and January 2009, the Fed doubled the quantity of dollars in existence, but the effect on overall liquidity was even more limited – it increased by just 4 percent – as was the effect on inflation. Thus, we can say a de profundis for the risk of inflation.

Even if we extend the temporal horizon – introducing the issues of demographic trends, as well as the future of globalization – the contrast does not seem to diminish at all. Not to speak of the role of fiscal policy. In this area, the big news comes from the United States, with the appointment of Janet Yellen to Treasury, accompanied by the expectation of an aggressive fiscal policy. How do the hawks and doves line up on this subject? The response depends on the link we expect to exist between an aggressive fiscal policy and the effects on inflation dynamics, starting from the assumption that the Fed's monetary policy will continue to be expansive for at least all of 2021, interest rates included

In this case as well, hawks and doves have opposite opinions. For the doves, an aggressive fiscal policy would certainly have expansive effects on Americans' income, including through the increase of public debt. There could be two channels of transmission of the economic expansion: on the one hand, a net increase of public spending would increase incentives for families and businesses to increase consumption and investment, with the relative multiplier for economic growth. At the same time, an increase in public debt, if perceived as an increase of private wealth, would go in the same direction. The effect on inflation would instead be negligible, if there are no structural changes in how the production of goods and services is organized, along with the labor market. Until now, those factors have suppressed the dynamic of consumer prices. The doves support the idea that the mix between an aggressive Yellen at Treasury and an accommodating Powell at the Fed will lead to growth without inflation, based also on what happened in the United States after 2008.

The combination of fiscal and monetary policy was very expansive at that time. The decisions by President Obama between October 2008 and January 2009 – supported by Congress – led to interventions of over 10 percent of U.S. GDP, with debt growth of 91 percent; it was the largest fiscal expansion in peace times since the Great Depression of the 1930s. Symmetrically – as we have recalled above – the Fed exponentially increased money creation, by over 100 percent. In the end, if we look at the overall data between 2010 and 2019, the economic growth rate was 2.25 percent, while inflation rose by 1.75 percent. Thus: satisfactory economic growth, without a rise in inflation.

The hawks shake their heads, based on a principal, although not unique argument: an aggressive fiscal policy, that translates into a systematic increase of the U.S. deficit and debt, produces price bubbles. They can be consumer prices, but also the price of financial assets, or the price of homes, or a combination of the three possible hot spots. Naturally, the bubbles may not be evident immediately. In particular, in situations in which uncertainty accentuates the risk aversion of families, businesses, and banks, the risk of bubbles remains latent, until better economic prospects trigger consumption, credit, and investment, with unforeseeable effects on the three types of prices. The hawks, looking at the same post-2008 data, note that the doves tell only half of the story: the increased aversion to risk never led to the growth of money and credit, and thus of aggregate demand, at the same speed the Fed tried to inject it into the system. Total credit returned to pre-crisis levels only in 2014; consumer credit only in 2016. The risk of bubbles is still latent.

An estimate consistent with that approach assumes inflation growth of over 5 percent by 2022; due also to the fact that the Fed, modifying its modus operandi in monetary policy, is in fact contributing to keeping the embers of the bubble hot below the ashes. In particular, the hawks point to the reform by which the Fed decided in 2008 to remunerate banks' deposits at the central bank. As a reflection, the excess reserves of banks increased enormously, along with the risk of bubbles. So Yellen the fiscal dove, with Powell the monetary dove, are a real detonator according to the hawks.

Between hawks and doves, the financial markets currently have no doubts: they are absolutely on the side of the doves, and rooting for the dove Yellen to design a fiscal "whatever it takes." There is still the unknown of the Congress, of course, but the support remains.

The debate on the relationship between monetary and fiscal policy is no less lively in Europe. The ECB's message for the coming months is very explicit: monetary policy will continue to be extraordinary as long as there is a need for it. But it is a message whose credibility is based on two assumptions. On the one hand, that the central bank can design and implement monetary policy independently; on the other, that fiscal policies – at both the European and national level – are up to the task. The fact that the two pillars are indispensable is evident from the model of analysis that has emerged to date from the language of the ECB. The pandemic recession appears to be a mix between two different types of unfavorable economic situations. On the one hand, the macroeconomic trend has followed a dynamic consistent with a so-called "V-shaped" recession: a non-economic shock has provoked negative economic effects on the behavior of families and businesses, that are very grave and significant. At the same time, though, it is quite likely that those effects will be temporary, in relation to how effective and durable the health solution – and vaccines in particular – proves to be.

In a V-shaped recession, the task of economic policy is clear: everything necessary must be done to reduce the dimensions and depth of the "V." For the ECB, this means ensuring that the mechanisms of transmission of liquidity continue to function systematically and regularly. Thus monetary policy must have the maximum flexibility, so as to ensure that the positive effects of monetary actions are as uniform as possible. At the same time, though, the pandemic crisis shows the traits of a "K-shaped" recession: not al businesses, and not all sectors, or all families, suffer the costs of the recession in the same manner. There are winners and losers, redistribution effects are triggered, or inequalities are accentuated. Monetary policy cannot ignore the effects on distribution, because redistribution policy is the legitimate perimeter of government in office. If monetary policy becomes redistributive, there is no reason it should be delegated to the ECB, that is, to an independent bureaucracy.

This is where fiscal policy comes into play: it is the responsibility of Brussels and national governments to address the economic risks – and as a result the social and political risks – that the K-shaped recession provokes. But if fiscal policy is not activated, the danger grows that monetary policy will be charged with duties and expectations that are both excessive and improper. As a consequence, the risk increases that the actions of the ECB will be judged insufficient or ineffective. The paradox then arises: there is a tandem, where one cyclist pedals as hard as possible, taking on risk – monetary policy – while the other doesn't pedal at all – fiscal policy; but the criticism affects the cyclist who is pedaling. Yet if the central bank loses credibility, there can be negative effects on expectations for inflation. So we come back to the starting point: the future of inflation does not currently seem to have a predictable outcome.


To learn more

Blanchard O., 2020, Is There Deflation or Inflation in Our Future? Vox, April 24.

Bordo M.D., Levi M.D., 2020, Do Enlarged Fiscal Deficits Cause Inflation? The Historical Record, Hoover Institution, Economics Working Papers, n.20124.

Brunnermeir M.K., 2020, Inflation and Deflation Pressures after COVID Shock, Princeton University, May 12.

Burdekin R.C.K., 2020, The US Money Explosion of 2020, Monetarism and Inflation: Plagued by History? Modern Economy, forthcoming.

Furman J., Summers L., 2020, A Reconsideration of Fiscal Policy in the Era of Low Interest Rates, Harvard University, mimeograph.

Goodhart C., Pradhan M., 2020, Future Imperfect after Coronavirus, Vox, March 27.

Miles D., Scott Andrew, 2020, Will Inflation Make a Comeback after the Crisis Ends? Vox, April 4.


Donato Masciandaro is a Professor of Political Economy at the Bocconi University, where he holds the Intesa Sanpaolo Chair in Economics of Financial Regulation. Since 1989 he has written for the newspaper il Sole 24 Ore. Since 2005, he has contributed to Economia & Management drawing on and developing his comments and analysis published in that economic-financial daily.

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