Is there deflation or inflation in our future? Some observers point to falling commodity prices, stumbling oil prices, and a depressed labour market and see low inflation, perhaps even deflation as far as forecasts go. Others point to the very large increases in fiscal deficits and central bank balance sheets and see inflation, perhaps even high inflation.
I put most of my probability mass on the low inflation forecast. But I cannot completely dismiss a small probability of high inflation.1 Let me explain.
The standard way of thinking about inflation is to look at the state of the labour market, inflation expectations, and shocks to commodity and food prices. This framework has served us decently well (not great, as attested by the debates about the death of the Phillips curve, see Blanchard 2017) for the last 30 years. And through those lenses, it is hard to see inflation pick up any time soon.
Unemployment is exceptionally high, and even if, when the lockdown is relaxed, it will be partly matched by exceptionally high vacancies, it is hard to see a strong wage push on the horizon. Commodity prices have fallen, oil prices have collapsed, putting downward pressure on inflation.
One might have worried that the large fiscal programmes to help liquidity-constrained households and firms would lead to demand exceeding the lower available supply. It has not happened, as there has been a large increase in saving, both because of the limits on shopping from social distancing and because of precautionary saving. While the price of some products has increased, inflation rates have, if anything, decreased since the start of the lockdown. (In the US, the consumer price index decreased by 1.2% at an annual rate from February to March). One may still worry that, when social distancing is relaxed, pent up demand will lead to a burst of spending, and some inflation. If it happens, it is unlikely to be large and long enough to destabilise inflation expectations, and it is likely to disappear quickly.
Looking beyond that, it is hard to see strong demand leading to inflation. Precautionary saving is likely to play a lasting role, leading to low consumption. Uncertainty is likely to lead to low investment; unlike a regular war, there is no capital to rebuild. The challenge for monetary and fiscal policy is thus likely to be to sustain demand and avoid deflation than the reverse.
This is why I put most of my probability mass on low inflation for the few years to come. We are, however, definitely operating in a non-standard environment and the standard way of thinking about inflation may be wrong. And I can think of a scenario where there is high inflation.
I believe that three elements must combine for such an outcome.
- First, a very large increase in the debt to GDP ratio, larger than the 20-30% or so under current forecasts.
This is not a crazy hypothesis. The exit from the disaster relief policies may be very slow, leading to large deficits not only this year but also next. The early start of deconfinement is likely to lead to more waves, a second and perhaps more after that. Given the precarious state of many households and firms as a result of the first wave, each successive wave may well require more and more fiscal spending for disaster relief. Multiply the initial fiscal package by 2 or 3 and this leads to a large increase in the ratio of debt to GDP.
- Second, a very large increase in the neutral rate, that is the safe real rate needed to keep the economy at potential.
This may be because the demand for sovereign bonds is downward sloping, and the increase in supply requires an increase in the rate for investors to absorb it. We do not have a precise sense of the effect, and the range of estimates is that an increase of one percentage point in the debt-to-GDP ratio increases the neutral rate by 2-4 basis points. So, assuming an increase in the ratio of debt-to-GDP of, say, 60%, this might lead to an increase in the neutral rate of 120 to 240 basis points, an increase that would get the neutral rate close to or above the growth rate. Or the neutral rate could increase for other reasons, a decrease in saving, an increase in investment demand, a decrease in risk aversion; none of these seems likely, but we have a sufficiently poor understanding of the determinants of the neutral rate in the past that we cannot exclude it.
- Third, and perhaps most important, fiscal dominance of monetary policy.
Faced with an increase in the neutral rate, the Fed should increase the actual policy rate in parallel, in order to avoid overheating. But this would increase debt service, requiring a potentially large fiscal adjustment to avoid a debt explosion. The government might be tempted to ask the Fed to keep the interest rate low, so as to decrease the debt burden. While today’s Fed would not yield to such pressure, a future Fed, with a chair appointed by a populist president, might be more willing to bend and keep rates low for too long, leading to overheating and inflation. While some inflation is desirable, the lessons from past episodes of high inflation is that this process typically ends badly: inflation expectations might de-anchor, leading to higher and higher inflation, perhaps even hyperinflation. This would reduce the real value of the debt, but not without major costs for the economy.
As I have made clear, this scenario requires the combination of three ingredients, each of them with low probability. Put your own probabilities and multiply them: the resulting probability is very small. I asked some of my colleagues for their probabilities, and the product always came below 3%. (The probability is even smaller in the euro area, where it is hard to see the fiscal authorities get together to impose fiscal dominance on the ECB.) But it is not quite zero.
Looking at the yield curve for inflation-indexed bonds, investors do not appear to anticipate anything like this scenario. They do not see a substantial increase in the neutral rate: the yield curve for inflation indexed bonds is negative throughout the maturity structure. They do not see an increase in inflation any time soon: the expected inflation proxied by the difference between the rate on nominal bonds and inflation-indexed bonds is about 1% below the Fed target of 2% throughout. I am on their side, but I do not completely dismiss the probability that things could turn wrong.
Editors' note: This column appeared on the PIIE RealTime Economics Issues Watch blog.
Blancard, O (2017), “Should We Reject the Natural Rate Hypothesis?”, PIIE Working Paper 17-14.
Blanchard, O (2019), “Public Debt: Fiscal and Welfare Costs in a Time of Low Interest Rates”, PIIE Policy Brief 19-2.