The Covid-19 pandemic has resulted in a sudden stop to much of economic activity, which prompted a quick fiscal and monetary policy response. The results are large government deficits and central bank liquidity injections. These parallel a steep rise in the household saving rate. All of these effects go in the direction of increasing the money supply, and so the question arises whether a bout of inflation will result after the Covid-19 crisis subsides.
The short-term situation is one of lower inflation, as demand restriction dominates supply disruptions. And so the debate among central bankers is whether they need to engage in further monetary stimulus. The ECB's pandemic emergency purchase programme started out as a financial stability instrument, but it has now taken over the QE function from the old public sector purchase programme
The ECB has revised down its inflation outlook, and has used this to justify an expansion of the PEPP both in time and volume. A story from Bloomberg surveys the spread of opinion by national central bankers, some of which such as the Spanish or Finnish ones worry about the risk of deflation, while others such as the Austrian argue that low but positive inflation is nothing to worry about. But the ECB seems confident it will be able to react in time if inflation pressures were to materialise.
In the medium term, however, the question is whether the increase in the money supply will filter out to prices as the economy recovers from the recession induced by the Covid-19 lockdowns. This will depend on how quickly demand and supply recover in the coming months. But the potential for an inflationary spike exists. The following chart compares the growth of the monetary base, mostly central bank reserves, and the broad money supply M3 over the euro's history.
The salient feature of the chart is that the two quantities used to grow at the same rate, but became decoupled since the global financial crisis in 2008. Simply put, the question is whether there is a risk that the broad money supply could about triple in size to go back in line with base money, thus causing high inflation.
The chart is in German because it comes from a high-profile debate between Peter Bofinger, formerly in the German council of economic experts, and Hans Werner Sinn, president of the Ifo institute and a long-standing critic of ECB non-conventional monetary policies. In a joint interview with Die Zeit, and now on Twitter, the two have been arguing whether the increase in the money supply risks inflation down the line. Both seem to agree that, at the moment, the economy is in a liquidity trap with high reserves and low growth of broad money. This manifests itself in low credit demand, low credit growth, and high cash holdings. But they disagree on the precise interpretation of the term liquidity trap, and on the mechanism for inflation. Bofinger argues that the increase in base money in recent years demonstrates that central bank reserves are not an essential determinant of the money supply. Sinn argues that, in a liquidity trap, credit demand remains low which prevents base money from filtering into the broad money supply and fuelling inflation.
What has changed is that, as we pointed out yesterday from ECB money-supply data, the Covid-19 crisis has led to an increase in credit to the public sector and private firms, and so an acceleration of the growth of the money supply. Regardless of the economists' disagreement on the mechanism, the fact is the money supply is now growing. Will this be a durable trend, or is it just a reflection of the use of credit to tide the economy over the lockdown? Another possibility is that increased debt loads from the Covid-19 crisis will further depress credit demand in the medium term, which would be a deflationary pressure. We also note a comment by Florian Kern in the same Twitter debate, arguing that the ECB has tools to prevent central bank reserves from fuelling excessive money growth if it came to that. It can raise the deposit rate it pays on excess reserves, for instance. His view is that the quantity of reserves does not play a role in inflation if the central bank can adjust the interest it pays on reserves.
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