Economy  

Will inflation upset the markets?

Will inflation upset the markets?
 Roger Kisby/Bloomberg

With the success of the vaccine rollout in the US and UK, and the likelihood that vaccine supply will improve in Europe during the second quarter of the year, Covid-19 is becoming less of a risk factor in the eye of the market.

Instead, as fiscal stimulus in the US and elsewhere flows into the global economy, markets are increasingly seeing the eventual withdrawal of very generous central bank liquidity (by raising interest rates and/or reversing quantitative easing) as the biggest threat to continued equity performance.

This in turn is leading to a lot of debate over the economic force that could cause central banks to tighten monetary policy earlier than expected: inflation.

Some investors are worried that unprecedented fiscal stimulus, particularly in the US, combined with easy monetary policy and pent-up savings could lead to a pick-up in inflation.

Their concern is that supply chains and businesses scarred by lockdowns will struggle to deal with soon-to-be booming demand, leading to spiralling price increases.

"Too much money chasing too few goods" is the common description of such demand-pull inflation, and it is undoubtedly true that the amount of money has increased significantly post-Covid due to government and central bank crisis measures – the M2 money supply in the US increased by more than $4tn (£2.8tn), or more than 25 per cent, since the beginning of 2020.

Classic equation

That said, money supply growth is not the only factor influencing the level of inflation.

The classic equation behind the ‘quantity theory of money’ is MV equals PT, where M is the quantity of money, V is the speed (velocity) of money flowing about the economy, P is the level of prices and T is the aggregate real value of transactions (that is, the real value of all the 'stuff' the economy produces). Thus, if you assume that V and T remain constant, inflation (the change in P) is proportional to changes in the supply of money (M).

However, presuming that the velocity of money (V) and the aggregate value of transactions (T) all remain constant is a rather ambitious set of assumptions.

One of the reasons we did not have inflation after the global financial crisis, even with the huge amount of quantitative easing put in place by central banks, was that most of the new money created went to banks that then parked it, unused, in their central bank reserve accounts as a liquidity buffer. M increased, but V decreased proportionately, and so there was no explosion in inflation as feared.

Those currently on the other side of the inflation debate – and this includes central banks at present – argue that something similar will happen this time too. They argue that any increases in inflation are likely to be temporary in nature because the world is currently awash with spare capacity, particularly in terms of people (otherwise known as high unemployment in the labour market).

So, the increase in demand as populations are vaccinated and exit Covid restrictions is going to be met by falling unemployment rather than permanently higher inflation. In effect, as unemployment decreases, more goods and services will be produced, which will increase T, without P needing to increase too much.