After several decades of relatively low rates of inflation, it is easy to think that we will continue to see little change in prices. But the seeds of inflation have been planted.
Purchases of financial assets, primarily Treasury securities, are the primary tool the Fed uses to control the money supply. When the Fed purchases Treasury securities, it provides the federal government with spendable funds. When these funds are spent, the money supply increases. Essentially, money is created out of nothing.
Since 2008, the Fed has expanded these purchases far more rapidly than in the past. Fed holdings of financial assets quadrupled during 2008-2019, expanding from $900 billion to $4.1 trillion. During the past 12 months, these purchases have surged another 80 percent, soaring to $7.47 trillion In February 2021.
Until now, however, the inflation rate has remained relatively low. Two factors have combined to keep inflation in check. Starting in October 2008, the Fed began paying banks interest on their deposits held with the Fed. These interest payments encourage banks to hold larger Fed deposits, rather than undertake investments and extend loans. During 2008-2019, the Fed used these interest payments to induce banks to hold a larger share of their assets as reserves, dampening the money growth and inflationary effects of the Fed’s huge expanded purchases of financial assets.
In addition, worldwide interest rates declined to historic low levels during the decade following the Great Recession. A variety of factors caused this. One that has been largely ignored was a dramatic demographic shift in high-income countries, as the number of people in the lending phase of life (roughly age 50 to 75) increased relative to those in the borrowing phase (under age 50). The resulting low and declining interest rates reduced the opportunity cost of holding money, causing the velocity or turnover rate of money to plummet. As the result of this combination of factors, the Fed’s huge increase in purchases of financial assets and money creation has, to this point, exerted only a minimal impact on inflation.
However, this favorable scenario is about to reverse course. Three major factors underlie the reversal.
First, the Fed’s current money creation dwarfs those of recent decades. Propelled by the $3.6 trillion Covid-19 spending financed by borrowing from the Fed, the narrow measure of the money supply known as M1 has expanded from $4.0 trillion to $6.8 trillion during the past 12 months, a 70 percent increase. By way of comparison, the 12-month increases in M1 during the inflationary 1970s never exceeded 10 percent. The largest previous single-year M1 increase in recent decades was a 21 percent figure in the aftermath of the Great Recession. The story is the same for the broader M2 measure of money, which has increased by 25 percent during the past year. The next largest 12-month expansions in M2 during the past 75 years were the 1975-1976 increase of 13.8 percent during the double-digit inflation of the 1970s and the 10.3 percent increase during 2011.
One has to go all the way back to World War II to find anything comparable to the money supply increases of the past 12 months. Moreover, even these gigantic figures understate the current monetary surge. The Treasury is currently holding more than a trillion dollars of committed funds in its bank account, which will be added to the money supply when they are spent in the next few months. Congress is expected to add additional fuel to the fire with the $1.9 trillion spending package currently under consideration.
Second, the inflation triggered by the huge monetary expansion will increase the expected rate of inflation and nominal interest rates. In turn, the higher nominal interest rates will cause the velocity of money to increase, unleashing additional inflationary pressures from the rapid money growth of 2008–2019. Rising inflation rates and higher nominal interest rates are two peas in the same pod. When the former occurs the latter will follow. As inflation pushes nominal interest rates upward, the recent reductions in velocity will reverse, adding to the inflationary pressure.
Third, the mandated shutdowns have resulted in a huge pent-up demand. Once a sizable share of the population has received the vaccine and the virus is brought under control, spending will increase substantially, providing an additional boost to both demand and the general level of prices. While the shutdown imposed large costs on small businesses and employees who lost their jobs as the result of business closures, the income of another sizable share of Americans continued as usual. In fact, the incomes of many in this group received an additional boost from the government’s direct payments to households in the Covid relief packages. Restrictions on travel, tourism, sporting events, and other entertainment curtailed spending and the personal savings rate more than doubled, jumping from 8 to 17 percent during 2020. Now, many people who have money have been cooped up for too long, and when they can, they are going to spend “big time.”
The current situation is similar to that of World War II and its aftermath. As during the pandemic, the surge in government spending during the war was financed mostly by debt and money creation. Similarly, spending options were severely limited during both of these events. The performance of the economy after the war provides insight on our likely future. Propelled by pent-up demand and wartime savings, the post-war recovery was stronger than expected. But it was also characterized by inflation. The CPI and GDP deflator (two measures of inflation) both increased at double-digit rates during 1946 and 1947.
The next two or three years are likely to be similar. It is a virtual certainty that inflation will rise, perhaps to double-digit levels. Demand will be strong and real GDP is likely to grow, albeit at a sluggish rate. Currently, the political forces supportive of anti-growth policies such as trade restrictions, higher minimum wages, perverse energy regulations, and cronyism appear to be on the rise, and they will dampen future growth. These policies, along with the uncertainties accompanying inflation and the burden of financing the larger outstanding debt will slow real growth. But inflation is going to be the big story of the post-pandemic economy. Get ready for an inflationary ride.
The author would like to thank Jane Shaw Stroup, Joseph Connors, and David Macpherson for their assistance in the preparation of this article.