“It’s like déjà vu all over again.” – Yogi Berra
In my last inflation blog post, dated 10 November 2020, I addressed a question that many clients have been asking lately: Are we about to enter a global “inflation era”? My short answer was (and still is) not right now, but potentially down the road. By way of follow-up, I thought I’d compare today’s inflation worries with those that arose during the quantitative-easing (QE)-fueled period after the 2008 global financial crisis (GFC).
The current inflation concerns, set amid a world of growing central bank balance sheets, ballooning fiscal deficits, and unprecedented policy innovation, echo the inflation fears raised in the post-GFC era. In the end, those latter fears proved to be unfounded, as inflation continued to decline over the ensuing decade. Why would this time be any different? To answer that, it helps to understand what the QE measures enacted in response to the GFC were actually intended to do — and why they were, in fact, not “inflationary.”
Transmission broke down…
Turning first to what post-GFC QE was designed to do, it was really to ensure the continued efficacy of monetary policy with regard to the real economy. This monetary-policy impact is indirect, occurring via a “transmission mechanism” whereby central banks’ reduction of front-end interest rates is transmitted across the yield curve and into the credit markets, lowering the cost of capital and stimulating the economy by spurring investment and consumption.
The problem encountered during the GFC — and the problem QE was meant to fix — was that this normal transmission mechanism broke down, as bond yields further out the yield curve did not come down along with short-term policy rates. QE programs were launched to correct this by directly lowering the yields further out the curve. Thus, QE was more or less about making monetary policy work more efficiently.
And inflation remained MIA
Secondly, why did these massive bond-buying programs not lead to post-GFC inflation? For two reasons:
- The size of the bond purchases ultimately didn’t matter, as post-GFC QE was essentially “asset swaps” (not “money printing”). That is, when a central bank bought a bond from a market investor, what happened was a “swapping” of a specific value of US Treasuries for the exact same value of cash. There was no net “creation” of assets, just a change in the composition of those assets. Such transactions improved the transmission mechanism by putting downward pressure on yields across the yield and risk curves.
- From an inflation perspective, only the impact of the subsequent increases in consumption and investment (the transmission mechanism) affected the real economy. Why didn’t this lower-rate-induced consumption and investment stoke inflation? Largely because post-GFC consumption and investment were partly constrained by banks and households needing to rebuild their own balance sheets and savings, blunting (to a degree) the lower-yield impetus to spend and borrow more.
Why inflation worries this time are different
This time around, I think it’s fair to say that global central bank actions are not primarily about making monetary policy more effective; that “ammunition,” so to speak, has largely been spent.
Instead, I would argue that the steps taken by central banks in 2020 have been more about keeping yields down so as to provide adequate space for fiscal stimulus to have its desired effect. And, unlike QE, fiscal stimulus (in the form of government spending and tax cuts) directly impacts the real economy by boosting economic activity. To the extent that this increased activity cannot be met by spare capacity in the system, prices (inflation) should rise.
This is not to say that higher inflation is necessarily a given going forward; it isn’t. What I am saying is that the structural reasons for potentially higher inflation are clearly different this time around. It would be a mistake, in my view, to make any assumptions about future inflation based solely on inflation’s failure to materialize in the wake of the GFC.
This is the second in my inflation “series” of blog posts based on ongoing client conversations. The next one in the series, due out in January 2021, will explore how changing inflation can upset the critical equity-bond relationship in client portfolios.