Inflation is good for economies as it drives consumption. If you think something will be cheaper tomorrow, you will hold off buying it until the price falls. Production will fall and people will be laid off. Companies can then pay staff less as they can be easily replaced. By prices increasing over time, production continues and as long as wages increase also, everyone is happy. In general, Central Banks target an inflation rate of 2% per annum. In Ireland, the Consumer Price index over the last 10 years has been 0.61%.
With the outbreak of Covid 19 and its impact around the world, we have seen that $11 trillion has been pumped into the markets by Central Banks all around the world. With all this money sloshing about, are we looking at high inflation over the next few years?
It is important to distinguish between monetary policy and fiscal policy. Monetary policy is a central banks way to control money supply to achieve their goals. You may remember back in the credit crunch crisis, the ECB pumped billions of euro into the banks that showed up in their bank reserves. The important thing to note in that case was the money didn’t actually enter the market.
Fiscal policy is the means by which a government adjusts its spending and tax rates to influence the economy. And it involves real money entering the market.
Central Banks control monetary policy. But with them printing so much money, they have been buying securities in companies as well as government debt. This is giving companies access to large amounts of real cash and there is more money in the system. Some will argue that this money is just keeping what are seen as good businesses open during a crisis. But if it goes on long enough, say for another 6 months, inflation will start to increase.
Consumer spending may also drive up inflation. Most modern economies have some form of Covid payment, with some people receiving more not to work than they would have when they were working. Lots of people have been saving as they don’t have a cost of going to work and nothing to spend their money on besides groceries. When the worst is past, they will want to spend again. But with the disruption to the supply chain, demand may outstrip supply and so prices will go up.
It will be the same with services. Lots of businesses will just not be able to reopen. Again, demand will be greater than supply. Add in social distancing rules and businesses like hairdressers will simply not be able to do as many hair cuts in a day. To stay profitable, they will increase prices to stay open and after 4 months without a haircut, there will be plenty of people willing to pay the higher price.
This really is a fine balancing act for the Central Banks. They have to keep pumping money into the system to keep businesses open and ensure banks don’t run into liquidity problems through companies defaulting on their loans. But if it goes on for too long, we might see inflation increase sharply.
If you have any questions, drop me an email at steven@bluewaterfp.ie