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Even as the fallout from the coronavirus pandemic and Great Shutdown manifests itself in the economic data, some economists are already warning that the Federal Reserve’s aggressive money-printing operation is laying the groundwork for inflation.
The Fed began open-ended buying of Treasuries and agency mortgage-backed securities on March 23 “to support the smooth functioning of markets.” Since that time its balance sheet has swelled by $2 trillion to $6.7 trillion.
How likely is an outbreak in inflation before such time as the economy fully recovers? Highly unlikely. The immediate concern is disinflation, or even deflation.
The forced shutdown of the economy mandated by the pandemic has created a deep hole in the nation’s output: something close to 10%, if estimates for a steep decline in second-quarter growth are correct. That hole is not going to be re-filled anytime soon. Some economists don’t see a full recovery in output and employment, which could exceed 20%, until the end of 2022.
Shocks to the economy
Until the economy reaches something approximating full employment, there is little chance of an inflationary outbreak.
When the economy shut down in March by order of the government, the sudden loss of output constituted an adverse supply shock. Factories closed and supply chains were disrupted, limiting the supply of goods. Many services industries, such as restaurants, hotels, and sporting arenas, ceased operations as well.
The central bank has no role to play when it comes to supply shortages. It can’t produce crude oil or ventilators or provide travel services.
The central bank’s domain is the demand side of the economy. It uses interest rates to change the incentive to spend versus save and in so doing, increase or decrease aggregate demand.
In the current situation, the sudden supply shock from the shutdown was matched by perhaps an even more extreme demand shock, which calls for a Fed response. Americans were confined to their homes, their activities limited to purchasing necessities, such as food and household supplies. They didn’t go to the mall, concerts or movies, or take vacations requiring air travel.
Subdued inflation
“Normally such demand and supply restrictions would have offsetting effects on price inflation,” write San Francisco Fed economists Jens H.E. Christensen, James M. Gamble IV, and Simon Zhu in “Coronavirus and the Risk of Deflation.” “However, the severity and public enforcement of social distancing and shelter-in-place orders suggest that constraints on demand will dominate.”
The economists argue that “uncertainty effects” may reduce demand enough to lower inflation by 2 percent points. Even so, they see the odds of outright deflation as “muted.”
Tuesday’s report on consumer prices demonstrates that there’s not much breathing room between 2 percentage points and deflation. The consumer price index fell 0.8% in April, the biggest decline since December 2008. That reduced the year-over-year increase to a scant 0.3%.
The core CPI, which excludes food and energy, fell 0.4%, the largest monthly decline in the history of the series, which dates back to 1957.
There were extremes within the report. Energy prices plummeted, as did the prices of apparel and airfares, while the price of food at home rose 2.6%, its largest increase since 1974. Egg prices rose 16.1% while household paper products (think toilet paper) posted their largest increase ever of 4.5%.
Related content:Coronavirus triggers record price drops for airfare, clothes and car insurance—but not these household staples
In order to produce inflation, or a significant increase in the price level, it would take a swift return to the status quo ante. And that isn’t about to happen.
For starters, the process of reopening the economy will be slow. Businesses may reopen, but consumers will be even slower to resume anything that resembles their pre-pandemic lifestyle until a vaccine is available. And the odds of another coronavirus outbreak in the fall are high, according to epidemiologists, which could cause a second round of shutdowns.
Heard it before
Following the Fed’s aggressive money-printing operations, known as quantitative easing, during and following the Great Recession, we heard the same warning about inflation. It never came to pass.
The funds rate remained near zero for seven years, never rising above a range of 2.25% 2.5% in late 2018 before the Fed started lowering the rate again in July 2019.
The Fed hasn’t been able to hit its 2% target for inflation on a sustained basis since announcing an explicit target in 2012, even in the face of the longest expansion on record with the unemployment rate at a half-century low of 3.5%. (The Fed’s preferred inflation gauge is the personal consumption expenditures price index.) Market-based inflation expectations have only moved lower to 1.5%.
So how likely is it that we will see a return of inflation now, given that the magnitude of the downturn far exceeds that witnessed in 2007-2009?
The onus is on the inflationistas to prove their case.
