Why Wasn’t “Money Printing” (Fed, ECB, etc.) Followed by High Inflation?
One of the most common questions that many people have about the economic consequences of the COVID-19 pandemic is why the massive expansion of central bank balance sheets did not lead to high inflation. After all, according to the classical quantity theory of money, if the money supply increases faster than the output of goods and services, then the price level should rise. This is what happened in some historical episodes of hyperinflation, such as in Germany in the 1920s or in Zimbabwe in the 2000s.
However, the reality is more complex than the simple equation MV=PY, where M is the money supply, V is the velocity of circulation, P is the price level, and Y is the real output. In this blog post, we will explore some of the reasons why the money printing by the Federal Reserve, the European Central Bank, and other central banks did not result in high inflation, at least not yet.
The difference between base money and broad money
One of the key distinctions that we need to make when we talk about money printing is the difference between base money and broad money. Base money, also known as high-powered money or monetary base, is the amount of currency and reserves that the central bank creates and controls. Broad money, also known as money supply or money stock, is the amount of money that is available to the public for transactions and savings. Broad money includes base money, but also other forms of money that are created by the banking system, such as deposits, loans, and other financial assets.
When the central bank engages in quantitative easing (QE), it buys government bonds and other assets from the private sector, and pays for them by creating new base money. This increases the size of the central bank’s balance sheet, but does not necessarily increase the amount of broad money in the economy. This is because the private sector may choose to hold the new base money as excess reserves, rather than lending it out or spending it. In other words, the velocity of base money may decline, offsetting the increase in its quantity.
This is what happened in the aftermath of the global financial crisis of 2008-09, when the Fed and other central banks launched their first rounds of QE. The base money increased dramatically, but the broad money did not. The banks were reluctant to lend, and the households and firms were reluctant to borrow, due to the uncertainty and deleveraging in the economy. As a result, the inflation rate remained low, despite the fears of some critics that QE would unleash hyperinflation.
The role of inflation expectations and credibility
Another important factor that influences the relationship between money printing and inflation is the role of inflation expectations and credibility. Inflation expectations are the beliefs that people have about the future path of inflation, and they affect the current behavior of consumers, workers, and firms. For example, if people expect higher inflation in the future, they may demand higher wages and prices today, which in turn may cause higher inflation. Conversely, if people expect low inflation in the future, they may accept lower wages and prices today, which in turn may cause lower inflation.
Credibility is the degree of trust that people have in the central bank’s ability and willingness to achieve its inflation target. If the central bank has high credibility, then people will believe that it will adjust its monetary policy appropriately to keep inflation stable and predictable. This will anchor the inflation expectations around the central bank’s target, and prevent them from drifting too far away from it. If the central bank has low credibility, then people will doubt that it will be able to control inflation, and they will adjust their inflation expectations accordingly. This will make the inflation expectations more volatile and sensitive to shocks, and make the central bank’s job more difficult.
The Fed and the ECB have established a high degree of credibility over the years, by demonstrating their commitment to price stability and their independence from political interference. This has helped them to keep the inflation expectations well-anchored, even during the periods of aggressive money printing. For example, the Fed’s preferred measure of inflation expectations, the 5-year, 5-year forward inflation expectation rate, has remained within a narrow range of 2% to 3% since the early 2000s, despite the fluctuations in the base money and the actual inflation rate. The ECB’s measure of inflation expectations, the 5-year, 5-year forward inflation-linked swap rate, has also remained relatively stable, although it has fallen below the ECB’s target of below but close to 2% since 2014.
The impact of the COVID-19 pandemic and the fiscal stimulus
The COVID-19 pandemic and the fiscal stimulus that followed it have introduced some new challenges and uncertainties for the relationship between money printing and inflation. On the one hand, the pandemic has caused a severe contraction in the global output and demand, which has put downward pressure on inflation. On the other hand, the fiscal stimulus has increased the government spending and borrowing, which has put upward pressure on inflation.
The central banks have responded to the pandemic by expanding their QE programs and providing liquidity and credit support to the financial system and the economy. This has increased the base money even more than before, but it has also increased the broad money, as the fiscal stimulus has boosted the income and spending of the households and firms. The velocity of money has also increased, as the economic activity has recovered from the lockdowns and the vaccinations have improved the confidence and optimism.
The net effect of these factors on inflation is still unclear and depends on the evolution of the pandemic and the policy responses. Some economists argue that the inflationary pressures are transitory and will fade away as the supply bottlenecks are resolved and the base effects wear off. Others argue that the inflationary pressures are persistent and will accelerate as the output gap closes and the inflation expectations rise. The central banks have signaled that they are willing to tolerate some overshooting of their inflation targets in the short term, but they are also prepared to tighten their monetary policy if needed to prevent inflation from becoming unanchored.
Conclusion
In conclusion, the relationship between money printing and inflation is not as simple as it may seem. It depends on many factors, such as the difference between base money and broad money, the role of inflation expectations and credibility, and the impact of the COVID-19 pandemic and the fiscal stimulus. The central banks have been able to keep inflation low and stable so far, despite the massive expansion of their balance sheets, but they may face some challenges and trade-offs in the future. As savvy investors, we need to monitor the inflation indicators and the central bank actions closely, and adjust our portfolio accordingly.
I hope you find this blog post helpful and informative. If you have any questions or feedback, please let me know. 😊
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