Despite the Bank of England and the Treasury’s coordinated moves to pump more money into the economy, inflation is unlikely to occur for now. Rather, the current crisis is generating deflationary pressures. Covid-19 shouldn’t prompt worries about inflation but rather a rethink of the concept itself.
The Bank of England’s moves to offer forms of monetary financing to the Treasury in the wake of Covid-19 have caused concerns over excessive inflation, but this panic is misplaced. Instead, as social distancing measures generate an unprecedented shock to the demand for goods and services, Covid-19 is a powerful deflationary force. In the UK, the latest figures showed inflation slipping by 0.2% in March, before the lockdown was even introduced.
Following the 2008 financial crisis, inflation hawks predicted that Quantitative Easing (QE) measures would turn high-income economies into the next victims of hyperinflation. Yet despite central bankers’ best efforts, the past decade has seen inflation remaining consistently below the 2% inflation target. The false predictions were based on misconceptions originating in the debunked theory of monetarism, the core of which Milton Friedman famously captured in the claim that inflation is “always and everywhere a monetary phenomenon”.
In reality, inflation is far more frequently a political rather than a monetary phenomenon, resulting from distributive conflicts, oil price hikes, and political crises in the most extreme cases. Further, price changes often vary across different sectors of the economy, driven by their own particular factors rather than a single policy pushing all prices in the same direction at the same time. Monetary policy alone has little control over the price of goods and services, and in most cases increased government spending generates increased output rather than inflation.
The unique feature of the current crisis is that the productive base of the economy is being intentionally held back, causing a shock to supply. In theory, this could potentially be inflationary, especially given that government spending is not currently stimulating increased production.
However, the widespread dampening of demand is outweighing the impact on the supply side of the economy, making deflation the more immediate threat. Despite Bailey’s fear-mongering about monetary financing and hyperinflation, the Bank of England clearly recognises the current risk of deflationary pressures. As Gertjan Vlieghe – member of the Monetary Policy Committee (MPC) – stated in a recent speech: “the MPC has decided to expand the Bank of England’s balance sheet, because we believe that if we do not, the economy will weaken further such that we would fall short of our inflation target”.
This doesn’t mean however that there is no cause for concern, as deflationary spirals are not to be taken lightly. The main danger lies in their impact on debt: as prices and wages drop, the nominal value of debt remains the same, meaning that in real terms the private debt burden intensifies. This is known as ‘debt deflation’ and is a primary culprit in producing widespread defaults and the triggering of financial crises.
The outlook for inflation once social distancing measures are lifted is highly uncertain. The main factor that could cause some inflation would be a spending spree, causing demand for goods and services to return significantly faster than supply. But if we enter a period of deflation now, this could slow the speed at which spending resumes even after social distancing measures are fully relaxed.
Rather than attempting to predict aggregate price movements in the coming months, time may be better spent rethinking the whole concept of inflation in the first place. Its standard measure – the Consumer Price Index (CPI) – calculates the aggregate change in the price of a basket of weighted ‘representative’ goods and services typically purchased by households (notably excluding house prices). Even in normal times, the CPI arguably conceals more than it reveals, as it aggregates vastly differing price changes across sectors.
Covid-19 brings this issue into sharp relief, as the lockdown has completely changed the average households’ typical purchases. Although the CPI indicated disinflation in March, prices for food, medicines and protective gear – more important than ever in the current circumstances – have increased. The impact of these changes is not reflected in the CPI, as households don’t typically spend so much on disinfectant, gloves, masks, and cold medicines. On the other hand, meals out, package holidays, and recreational and cultural services currently have a combined weight of 17.5% in the CPI, even though they are entirely absent from current consumption patterns. In these kinds of sectors, officials are even struggling to collect data on prices due to businesses being shut down.
Rather than a cause for concern, inflation is merely the latest economic concept that this crisis has thrown into question. As Covid-19 continues to run its course, inflation figures increasingly provide little insight into the actual living costs of ordinary citizens. As this crisis forces us to reflect on what is truly essential to our wellbeing, the time is ripe for rethinking our measures of inflation and the practice of targeting them, so that the Bank of England can truly fulfil its mission to promote the good of the people of the United Kingdom.