The Inflation Debate

The debate about whether or not inflation will surface from the COVID-19 pandemic has gained traction. There are, in my opinion, two main arguments for the belief that inflation is coming. The first is that in the United States, economists worry that President Joe Biden’s $1.9 trillion stimulus package, including $1400 cheques, is pouring more fuel on an overheating economy. 1.9 trillion dollars as a stimulus package is undoubtedly bold, and it does come with several risks. While it is certainly a valid cause to provide relief to families who have been negatively affected due to COVID-19, the stimulus should not be overdone. Vaccine production to combat the coronavirus has been soaring, leading to most industries reopening and more or less returning to pre-COVID-19 levels. The economy rebounding out of lockdown, combined with this new stimulus package, leads to the belief that it will overheat the economy and toward a period of inflation. 

This recession is comparable to the Great Recession during 2007-2009, and the stimulus efforts can and should be compared as well. The output gap, the gap between actual and potential GDP, is an important statistic to consider when looking at the stimulus package size. Figure 1 details the potential GDP from 2006 to current, and Figure 2 details the actual GDP from 2009 to current. Shaded parts in the chart represent the Great Recession and the recession caused by COVID-19.

Figure 1:

Figure 2:

In 2009, the output gap was around 80 billion a month and increasing, while as of right now, the output gap is approximately 50 billion a month and decreasing. In 2009, then-President Obama’s stimulus would provide more or less 40 billion to the economy, about half the output gap. President Biden’s stimulus would provide just over 150 billion a month, 158 to be exact. This is more than three times the output gap, which again supports the argument that this stimulus is pouring a little more fuel than necessary into the economy. Inflation could be a result of this. The issue that President Biden now faces is to still provide enough stimulus to help out people in need without threatening inflation and financial instability. 

The final and second argument that will be discussed of potential inflation is the increased personal savings rate. Figure 3 details the unprecedented spike in savings during the COVID-19 pandemic.

Figure 3: Personal savings rate as a percentage of DPI (Disposable Personal Income)

Lockdown has led to the inability to spend money, as vacations, restaurants and other such services have gone offline. Households are now loaded up with spendable cash, and this increased consumer spending in the coming months could trigger a period of considerable inflation as the economy starts to open back up, and people are liberated from the prison of their homes. This spendable cash is only going to go up with the recent stimulus. 

In addition to this, the recent selloff of fixed income securities has also solidified the argument that there is a fear of a coming inflation. Fixed income tends to do horribly in periods of high inflation, because the value of the payment decreases. The surge in interest rates, depicted in Figure 4, also shows the confidence in the recovery, and inflation.

Figure 4:

Commodities rose as well, with copper reaching over 9000 per tonne. Brent oil reached 64, and Goldman Sachs anticipates oil rising above 70 in the coming months. Interestingly, the rising interest rates, combined with the rally in commodities, theoretically, should not be happening. Commodities and interest rates are inversely related, and the fear of inflation can explain the recent increase in both. Investors are pricing in bets for economic growth, and thus, inflation. 

However, the reverse side of this argument has a lot to do with the belief that money supply doesn’t actually have a strong correlation with inflation. After a certain point, people won’t spend their newfound money, even if the price is cheaper relative to before, because they have more money. There are only so many products you can buy, and just because people have more money it does not necessarily mean that it will lead to increased consumer spending. A perfect example of how increased money supply does not necessarily correlate with inflation comes after the financial crisis. After this crisis, bond buying by central banks, known as Quantitative Easing (QE), was started in order to increase the money supply. Some monetary hawks were skeptical of QE, warning that it would reignite inflation. However, these hawks ended up looking a little silly. Inflation was kept in check, and nothing of alarm took place. Even with this, and economists such as Milton Friedman admitting the link between money supply doesn’t really exist in practice, we could be heading into a period of inflation. COVID itself has proven that the unexpected can happen, and this could very well hold true for a period of inflation. The return of an inflationary period should be considered as a possibility in the near future, and this debate should not be kept aside when discussing policies in the upcoming months. 

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Sources: Jared Dillian The Daily Dirtnap, Financial Times, Bloomberg, The Economist, Federal Reserve Economic Data