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The Inflation Puzzle

By Aditya Raj Bhandari

These are extraordinary times, which have warranted extraordinary policy action. Advanced countries such as the US, Japan, and the Eurozone are creating money at a previously unimaginable scale. The US’ M2 money stock has risen by nearly $3trn in the last 4 months alone. As such, it’s only logical for concerns regarding inflation to step in. However, there lies the puzzle. While money is being printed at an exponential rate, inflation remains absent. What’s happening?

To begin, it helps to understand why money is being created at its current rate. This has largely been a result of a policy broadly termed as Quantitative Easing (QE hereafter). This involves the central bank purchasing long term government bonds in the economy by creating money. However, central banks have now also been heavily involved in buying other kinds of financial assets under the ambit of Quantitative Easing. The choice of assets to buy is largely intrinsic to the economy in question.

QE serves a number of purposes in an economy, which makes it an attractive policy option when conventional routes are constrained. It injects liquidity through large scale purchase of financial assets from various investors. This helps in also keeping the yields on various assets in check, and specifically aims to target long term yields. For example, in a scenario where the corporate borrowing costs have risen due to a high risk premium, the central bank can initiate a corporate bond buying programme. This brings down the yield on corporate debt, and also provides a liquid secondary market to alleviate concerns in the minds of other investors in the economy. This is something the Bank of Japan has done through the current pandemic.

Some economic theory would largely suggest that such an exponential rise in the money supply should be inflationary in nature. After all, there’s a lot of money trying to buy too few goods and services. Production has indeed fallen in the US, and across most of the world. The NBER recently declared that the US officially entered a recession in February when it reached the peak of its record expansion.

This implies that the economy is producing fewer goods, which is being chased by much more money than ever before. Monetarism, specifically, dictates that the growth of money supply beyond the growth of national income should cause inflation. While there isn’t strong evidence in the favor of this theory, some agents would expect at least some inflationary pressure in an economy that is experiencing such tremendous growth in money supply.

Inflationary fears have in fact caused some sections of the policy circle to suggest scaling down the expansionary policies being pursued by the Central Banks, in light of the pandemic. It, then, becomes critical to understand how valid these concerns are and if inflation truly deserves a place near the top of our list of woes.

Despite the tremendous growth in Money Supply, price growth has remained subdued if not entirely absent in the US. The CPI for all Urban Consumers has actually fallen in the months of March and April.

To put things in context, this isn’t the first time unabashed monetary expansion hasn’t been inflationary. In the aftermath of the 2008 Global Financial Crisis, we noticed a similar rise in Money Supplies without inflationary pressures. However, at the time, the stimulus wasn’t directly focused towards households and their incomes. Things are different during this pandemic. Americans are getting tremendous unemployment benefits in the form of support from the government, and indirectly the Federal Reserve, which has actually led to a rise in Household disposable income despite nearly 20 million Americans losing their jobs. In fact, Personal Disposable Income in the US increased by nearly 14% between just March and April.

While it’s impossible to say what could be accounting for missing inflation without much more thorough research, it is useful to examine a potential cause that we are observing. Consumption Smoothing could paint a useful picture.

The Personal Savings Rate (as a Percentage of Personal Disposable Income) in the United States had risen to 33% in the month of April. To fully appreciate how much that is, it’s useful to note that the highest recorded rate before April was 17.5% during the aftermath of the 1975 recession. Households are devoting a much smaller portion of their incomes to consumption than ever before. On the surface, this seems rather obvious given that strict quarantine rules make consumption much more difficult and inconvenient. However, it’s unlikely that consumption will soar even once the economy reopens.

Economic models allow us to understand that we are witnessing tremendous consumption smoothing here, the idea that households like to smooth their consumption levels over a period of time instead of having high volatility in it. This implies that during recessionary periods, household expect their incomes to be subdued in the future. In order to maintain a steady consumption flow, they save a higher portion of their income today to bring into the future.


We are currently amidst a deeper recession than most of us have witnessed in our lifetimes, which paints a rather murky picture about the future. With US unemployment hovering around 15%, and subdued wage growth, households remain pessimistic about their future income flows. It’s incredibly unlikely that the governments will be able to keep the economy on life support for long which means the generous support will be withdrawn. In such a scenario, it makes sense for households to consume less today to support steady consumption tomorrow.

Non-economists will do well to understand that money supply is not a great indicator for inflation in modern economies. The lack of a relationship between the two led to the abandonment of Monetarism as a credible theory, and the reason why Central Banks don’t exclusively target money supply to handle inflation. The different nominal interest rates, and the resulting real rate of interest, in an economy instead do a much better job at this. Money Supply is simply a tool to influence a series of key nominal rates in the economy that enable the central bank to achieve its different objectives such as inflation, unemployment, among others.

Inflationary pressures have largely disappeared off late in countries like the US, Japan, and the Eurozone. There are a host of reasons for this trend which are beyond the scope of this article. Some academics believe that the natural real rate of interest in these economies, the rate at which the economy is at full employment and stable inflation, has fallen over time. This has allowed their central banks to sustain low policy rates over time without inviting inflationary pressures. In fact, a higher demand for savings at this point is likely to further push the neutral real rate of interest down which will only subdue inflationary pressures. The implication is that central banks can have more expansionary policies than they otherwise would be able to.

As a result, it’s unlikely that inflation becomes too big a problem as the recovery gets underway. Financial markets expect the Federal Reserve to miss its inflation target, of 2%, on an average over the upcoming decade. Concerns about inflation, as raised by a few sections of the policy and industrial circles, shouldn’t yet derail expansionary recovery efforts. Inflationary pressures could emerge as the economy rises from its slump, and starts moving toward the full employment level. However, we must first allow it to rise before hitting brakes on the recovery.

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