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A Case for Higher Inflation

13 October 2020 By Mircea Vasiu

The world as we know it changed dramatically with the COVID-19 pandemic. People no longer do things the way they did before, with extraordinary economic implications. 

Often viewed as a negative economic phenomenon, inflation refers to higher prices over a certain period. Much higher prices lead to hyperinflation, while lower readings, albeit positive, reflect disinflation. Deflation appears when inflation drops below zero. At that point, policymakers (i.e., central bankers) step up and intervene to bring inflation back into the positive territory.

However, inflation changes with time. It does not become deflation or disinflation overnight, meaning central banks have a heads up way before prices drop to such extreme as deflation appears. Usually, disinflation or deflation happens during economic recessions.

People postpone purchasing due to economic uncertainty. Do I really need the last P.C. or smartphone? Must I have the latest gaming console? These are just a couple of examples of things you and I do not consider during economic expansion. But are the first ones the consumer ditch during recessions.

The pandemic brought the second recession in the last decade. After the 2008-2009 Great Financial Crisis, the world did not quite recover before the COVID-19 recession began.

Growth rates were insignificant. Unemployment remained elevated (except in the United States). Inflation remained a problem.

Central Banks’ Glory Years

Controlling inflation is something central banks tried to do since inflation targeting was introduced. The 2% consensus refers to price stability as defined by central bankers.

Looking back over the last decades, one can easily state that central banks did a great job in controlling inflation. More precisely, the developed world did not suffer from high inflation – just the opposite.

Yet price stability at any cost is not something a central bank wants. The fact that central banks in the developed world managed to keep inflation close to the 2% target had much to do with demographics too. In Japan, the aging population made it difficult for prices to rise to a sustainable growth level. Now that China’s working class is aging, the world will be left without its main growth engine.

The perfect example of central banks’ monetary policy effectiveness is seen in today’s markets. The Italian and Spanish spreads are at historic lows – and continue to fall. At the same time, their economic situation is one of the worst ever.

Who is responsible for keeping the spreads low? The central bank.

Higher inflation is possible. It is just not a priority right now.

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