Given the slow pace of economic recovery it will be years before the choice presents itself
As the debate on where inflation will go in the years ahead continues, those arguing that a period of high inflation is coming are missing or ignoring an important consideration that will have a bearing on inflation outcomes. This is that the Covid-19-induced fiscal stimulus that is often cited as the reason for higher inflation expectations, and therefore bond yields in the US and other countries, is not permanent but transitory.
Fiscal consolidation at a global scale will have to follow soon after countries reach herd immunity and economic activity normalises, to reduce debt-to-GDP ratios that according to the IMF have reached almost 100% in many countries. But fiscal consolidation should, theoretically, be disinflationary not inflationary.
The argument for higher inflation is as follows. The unprecedented fiscal and monetary policy stimulus induced by the pandemic, the pent-up demand from forced savings while households were locked down, and the opening of economies as vaccination programmes gather momentum, will drive private demand up and therefore boost inflation.
The other reason from a historical perspective is that pandemic inflation and bond yield outcomes have been likened to wartime periods — they increased during and in the immediate aftermath of big wars. While this makes sense at first, these two reasons do not have much validity when well considered, even in a historical context.
The evidence is contrary to expected outcomes. Goldman Sachs looked at 12 big wars and pandemics going back to 1300 and concluded that higher inflation is not a natural consequence of pandemics, while wars have in fact resulted in higher inflation and bond yields, during and in the immediate aftermath. Likewise, they find that bond yields have tended to rise during and after wars while remaining steady or even moderating after pandemics. Historical precedent does not support the view that pandemic stimulus will lead to higher inflation.
The reason for these outcomes is that wars drive up public spending, and reconstruction investment after wars drives up inflation and bond yields. In contrast, private demand collapses during pandemics and since stimulus merely replaces this it does not drive up inflation.
Coming to pandemic-induced stimulus as the reason for expecting higher inflation, let me first isolate monetary policy stimulus as nonconsequential for inflation, a lesson learnt from the global financial crisis. The US Federal Reserve, European Central Bank and Japan have all failed to generate inflation over the past decade despite unprecedented money printing and bond buying programmes.
This time is no different. In fact, going back as far as the early 2000s, many prominent global economists expected hyperinflation in advanced economies, but we did not see it. Such heavyweights as James Turk and John Rubino, John Williams and Marc Faber, all forecast hyperinflation that never materialised. So monetary policy stimulus as a reason for high inflation expectations is out from a historical perspective.
As far as fiscal policy stimulus is concerned its impact on economic growth, inflation and bond yields is transitory. The 2020 and 2021 stimulus is likely to generate higher economic growth, as is projected by the IMF, this year and perhaps next. As far as its impact on inflation is concerned, higher inflation outcomes are not assured given the slack in the economy and the coming fiscal consolidation.
High levels of debt will constrain economic growth and render countries vulnerable to a normalisation of monetary policy. As such, developing countries must embark on fiscal consolidation to bring debt to sustainable levels. SA has already begun to consolidate, as was reflected in the February Budget Review. Consolidation is disinflationary not inflationary.
Given what I have outlined, higher inflation will be a policy choice where central banks deliberately remain stimulatory or through high administered prices, not a function of demand and supply dynamics. The SA Reserve Bank must not choose higher inflation policy, though given the slow pace of economic recovery it will be years before it comes to that.