The rate of inflation in the world’s leading economies, as well as in Malta, has now been very level for years. I have often commented in the past what may be some of the downside risks of inflation, and subsequently interest rates, were to increase. The question that is now being put is whether there is a risk of an increase in the rate of inflation in the US and in the eurozone sometime this year or in early 2022.
However, let us proceed in some form of order. Inflation is normally a sign of a booming economy. However, after the economic slump, which followed the financial crisis of 2008, economies picked up very slowly. Some never really picked up enough by the time of the next slump, this time caused by the coronavirus last year.
The rules of the eurozone hindered governments from having an expansionary fiscal policy. Therefore, it was left to the European Central Bank (ECB) to adopt a loose monetary policy stance to stimulate economic growth. Money became very cheap, with interest rates around zero. Moreover, both the ECB and the Federal Reserve of the United States continued to release liquidity into the market through their quantitative easing programmes.
Do governments and central banks have the required space to manoeuvre if inflation does become an issue?
Their stated policy was to achieve an inflation rate of two per cent and insisted on their quantitative easing programmes until that rate would have been achieved. The point is that it was never achieved and so, interest rates remained low and money remained cheap. By maintaining the cost of money low, central banks were hoping to persuade households and firms to purchase more cars, buildings and equipment. Some countries did eventually get economic growth but most of the national economies remained very vulnerable. In this regard, Malta was an exception, with growth rates exceeding five per cent.
Fast forward to 2020. We got the spread of the coronavirus with the result that a number of economic activities either slowed down or stopped for a period of time. Some such activities have not restarted yet, such as tourism, or have started at a very low level. All economies went into recession and, therefore, the inflation rate stayed down.
The difference this time round is that governments did adopt an expansionary fiscal policy with their stimulus packages. This happened in the US, the eurozone and in Malta. So both banks and governments pumped a large amount of money into the economy with the objective of mitigating the impact of the economic slump. There has been so much money creation in the economy that the monetary base in most economies is much higher than it should be, given the economic output of such economies. The unknown factor is what will happen once the coronavirus is brought under control thanks to the vaccines. Will consumption increase dramatically as a result of pent-up demand being let loose? Once consumption takes off, what will be the multiplier effects of such an increase? And this is where the issue of inflation comes in.
A report by the ECB shows that as much as three-fourths of the money base in the eurozone is not needed for the level of transactions that there are. Because of low consumer confidence, this money is being put in savings accounts and not being spent. However, once the level of consumer confidence increases and consumers start spending again, will the rate of inflation rise above that target of two per cent? What would be the policy options for governments and central banks at that stage?
Do governments and central banks have the required space to manoeuvre if inflation does become an issue? The tendency today would be to say that we will cross the proverbial bridge once we get to it. On the other hand, once inflation becomes an issue, we cannot postpone decisions any longer.