After the world has finally worked its way beyond the covid-19 crisis, it may have to confront a danger that almost everybody has forgotten: higher inflation. At the moment, it's the last thing investors and governments are worried about, which is exactly what makes the threat so plausible.
It has been decades since governments have lost sleep over high inflation. Especially since the Great Recession of 2008, their biggest anxiety has been just the opposite: Central banks have struggled to raise inflation to their target rates, and with interest rates stuck for years at the so-called effective lower bound (zero or a bit less), they've worried mainly about the risk of deflation.
That's the thinking currently priced into financial markets. There's no trace of higher inflation in any of the standard measures of expectations. And on the face of it, this makes sense. Covid-19 has delivered a strong deflationary shock to the system. Demand has cratered, despite strong fiscal stimulus and further recourse to unorthodox monetary measures. Yes, supply has crashed too, but the net effect so far appears to have been an even bigger shortfall than before of demand relative to supply - which is what "deflationary shock" means.
At some point, though, this could change. Suppose covid-19 causes significant and persistent long-term damage to worldwide production and supply chains. And suppose governments and central banks continue to fuel demand in an effort to support living standards as though that fall in potential output hadn't happened. In that case, you'd expect inflation to rise.
This thought complicates matters for risk-averse investors perturbed by the buoyancy of stock markets. Assets such as equities are a hedge against higher inflation (earnings go up when prices rise). Investors in medium- or long-term bonds, on the other hand, are very much at risk if inflation accelerates. Cash isn't so safe, either, once higher inflation starts eating away at its purchasing power.
This is unlikely to be a concern in the next few months or quarters. For now, unstinting monetary and fiscal support is surely necessary. But the subsequent unwinding of these measures won't be straightforward, and that's when the risk of higher inflation might emerge.
For one thing, levels of public debt are certain to be much higher, and in due course attention will turn to the steps needed to contain them. At that point, economies could still be a long way from full employment, because the post-coronavirus adjustment is likely to involve some restructuring of the economy, as opposed to merely rehiring people into their old jobs. Against that background, there'll be resistance to renewed "austerity" - meaning tax increases and cuts in public spending. Yet without deliberate fiscal tightening, governments could find it harder to persuade investors to keep buying their debt, which in turn would push bond prices down and interest rates up.
This would put the Federal Reserve and other central banks in a bind. Would they allow interest rates to rise and financial conditions to tighten before everybody was back at work and the pre-coronavirus trend of output had resumed? I wouldn't take it for granted. The Fed's dual mandate requires it to weigh employment as well as inflation; the European Central Bank's mandate doesn't, but that hasn't stopped the ECB from behaving as though it did. The temptation to maintain stimulus by any means necessary - and indeed the legitimate case for doing so - would be strong. That's an inflationary prospect.
There's another vital ingredient: The consensus of expert opinion has shifted - and, helped along by covid-19, is still shifting - toward denying any such danger.
As Keynes pointed out, the importance of ideas for public policy should never be underestimated. The recent retreat from the goal of trade liberalization followed disenchantment with the previous (and basically correct) conviction that trade is good. Something similar is happening with inflation. Most economists who express a view on it are deeply unalarmed, either because they can't imagine it coming back or because they rather hope it might. If or when inflation does start to rise, they'll be ready with reasons to let it happen, dismissing it as a blip or even, in some ways, a good thing.
Evolving opinion on central-bank independence is a related indicator. The doctrine of central-bank independence was devised in response to the inflation of the 1970s and 1980s. In effect, it took responsibility for maintaining price stability through monetary operations away from short-sighted politicians and gave it to wise technocrats. This contract was in jeopardy even before covid-19 because, with interest rates stuck at zero, central banks were forced to venture across the line into fiscal policy through bond-buying and other unorthodox measures. The pandemic could affirm these incursions as standard operating procedure.
The next phase in this debate has already started in Europe, courtesy of Germany's constitutional court. The underlying issue is whether central-bank independence should explicitly encompass quasi-fiscal tools, so that the ECB can keep on doing whatever it takes to support the euro system without political interference. Notice, though, that the new defense of central-bank independence isn't about keeping spendthrift politicians away from monetary policy, narrowly defined; it's about stopping fiscally conservative politicians imposing their supposedly groundless fears of inflation, excessive public debt and intra-EU transfers on economic policy writ large.
This kind of intellectual regime change is apt to have unintended consequences. Now that almost everybody's convinced that inflation is gone for good, I'd take the risk of a comeback quite seriously.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Crook is a Bloomberg Opinion columnist and writes editorials on economics, finance and politics. He was chief Washington commentator for the Financial Times, a correspondent and editor for the Economist and a senior editor at the Atlantic.