In the late 1970’s and early 80’s annual consumer price inflation in Ireland hovered around 20% and it would have seemed fanciful to anyone living through that period there would come a time when prices would hardly change from one year to the next. Yet, annual Irish inflation since euro membership in 1999 has averaged 1.8% and has been lower still in the last decade , at just 0.5%. Of course Ireland has not been unique in this regard, with inflation in the euro area averaging 1.4% over the past decade or 1.2% excluding food and energy.
The Covid pandemic has added additional disinflationary forces, with the demand shock trumping that on supply, at least to date, and annual inflation is currently negative across the euro area, including Ireland. Some argue , though,that this long period of largely stable prices may be coming to an end, in large part as a consequence of the policy measures taken to combat the economic dislocation caused by the pandemic.
Inflation, as Friedman noted, is everywhere a monetary phenomenon and the money supply is certainly expanding at a rapid clip in developed economies; in the US broad money supply growth was an annual 23% in August, while the July figure in the euro area was over 10%, including 13.2% in Ireland. In fact most of this is driven by overnight deposits, as households, in particular , are effectively forced savers as a result of economc restrictions, leading to a rapid build up of monies in current accounts that would normally be spent.
How quickly these deposits will be spent on a return to more normal conditions is one question but the broader monetary argument is that banks in Europe and the US now have an unprecedented amount of excess reserves, which can be used to create loans and hence money, so the potential is there for a longer period of excess monetary growth and inevitable inflation.
The Monetarist case is based on the Quantity Theory, which has an identity at its core- the value of national income (PY) equals the money supply (M) times the average number of times that money circulates ( V, the velocity of circulation). The theory assumes that V is pretty stable which if true means that monetary growth above the potential growth of the real economy will push up prices. V can and does fall, however, so ‘excessive’ monetary growth may simply be offset by a fall in Velocity, leaving national income little changed.
It is also the case that bank reserves are a necessary condition for loan growth but not a sufficient one , as the ECB has found in recent years. Firms and households may not be wiling or able to take on fresh debt and banks may also be constrained by low profitability and capital issues, leaving monetary policy essentially pushing on a string..We have also pointed out in previous blogs that the huge fiscal stimulus seen in response to the pandemic is not funded by monetary creation, at least to date, and will ultimately be paid for by taxapayers, albeit at a borrowing cost kept low by central bank purchases of government debt.
In a world of globalisation and largely free trade any excess demand for goods in a given country can anyway be met by higher imports, with little or no impact on the price level. On that view a generalised rise in inflation across the globe requires the elimination of excess supply at a global level and as central banks have discovered this makes it extremely difficult to achieve a desired level of inflation with monetary measures alone. The pandemic has ceratinly impacted supply but it is not clear there will be a significant long term impact on global capacity. Absent that, the structural factors that have kept consumer inflation low may well continue to work. Asset prices are different, though, in that excess demand there can and does lead to inflation, because supply is constrained, such as land and housing in a given country or equities via buybacks. So liquidity can certainly drive asset price inflation , if not consumer prices.