Last week saw the striking juxtaposition of two major items of economic news. On Wednesday it was announced that the inflation rate had fallen from 0.8pc to 0.5pc, while on Thursday the Bank of England said it would inject another £100bn into the economy, bringing the total to £300bn since March.
Any readers reared on the idea that inflation results from “too much money chasing too few goods” will be worrying that an inflationary upsurge must be around the corner. I know from my inbox that there are very many of you.
As the author of a book entitled The Death of Inflation, published in 1996, you might think that I would be relaxed about inflationary prospects. In fact, this is only partly true. The title reflected a bit of poetic license on my part. Admittedly, inflation has given a pretty good impression of being dead these past 25 years. But it can easily surge into life again. Could this be about to happen now?
The current economic situation involves a collapse of both supply and demand. The effect on the general price level could go either way. In practice, the demand element has been dominant. In aggregate, prices are now hardly going up at all, compared to a rate of increase of about 1.8pc before the virus.
The oil price crash earlier this year has been the dominant influence. Additionally, though, the price of most core items has hardly risen or, in some cases, actually fallen, reflecting weak demand.
Admittedly, in some sectors that continue to be affected by social distancing, such as airlines and hospitality, in coming months prices could be forced up, as businesses struggle to cover their costs. And oil prices are rising. Even so, most businesses will keep prices broadly stable.
Accordingly, both the headline and core rates of inflation should continue to fall over the next few months. From September onwards I expect inflation to rise again, but it should remain well below the Bank’s target rate of 2pc for the next two years or so.
The controversial issue, however, concerns what happens after that. The growth of the money supply has recently taken off. Over the last year, the broadest measure, M4, which covers all bank deposits, is up by 9pc. I expect the growth rate to rise further over coming months.
In practice, there is no need to start ringing the inflationary alarm bells just yet. We have seen such rates of increase before without suffering an inflationary upsurge. Whether one happens now depends upon several factors.
First, will the recent huge injections of government money, financed by money printing by the Bank of England, continue at recent rates?
Second, will the private sector recipients of this largesse willingly hold increased bank deposits, rather than spend them? Third, will the economy simply be able to grow its way into a position where it can absorb this excess money?
Fourth, will the banks be spurred by the presence of so many extra reserves on their balance sheets into increasing their lending? And, finally, will policy be tightened to stop inflation in its tracks?
At some point, we should expect the economy to return to working at something like full capacity. If at that point demand is increasing smartly, there will be upward pressure on inflation. What should the monetary authorities do then?
Restraining the banks from excessive lending is the comparatively easy bit. Special deposit requirements could be imposed on them, effectively freezing their reserves. Alternatively, reserve holdings could be reduced, while simultaneously also reducing the broad money supply, by the Bank selling some of the government bonds that it has bought during the crisis. This means switching from Quantitative Easing to Quantitative Tightening. (Mind you, that would cause other problems.)
So much, so conventional. But a large part of this monetary expansion results directly from the crisis spending by the Government, with the money landing up in the bank accounts of consumers and businesses.
Even if the Bank offloads debt into the markets, and even if this succeeds in reducing the broad money numbers by absorbing money held by investing institutions, this will do nothing to reduce the money holdings of consumers and businesses.
In principle, these holdings could be reduced if the Government runs a budget surplus – that is to say, collects more taxes than it spends, as a result of imposing big tax rises or expenditure reductions. Yet the time when this will be possible, and even desirable, is surely long distant.
This leaves higher interest rates as just about the only weapon available to try to stop an upsurge of inflation. As we know from the past, they are a blunt weapon. They work in the end, but often with devastating consequences.
In the past, governments and central banks have typically acted too late to head off inflationary dangers. Arguably this tendency may have gone into reverse in the Nineties, continuing until now.
But in this period the authorities have been fortunate that the disinflationary tide has been running strongly, thanks to globalisation, the weakness of organised labour and technological advance. Yet this will not necessarily be repeated in the next 10 years. Indeed, the tide may be flowing in the opposite direction.
I am not suggesting that now is the time to tighten policy. Quite the opposite. It is absolutely correct for the authorities to be providing maximum fiscal and monetary support. But things will change.
A lot of people seem to believe that all the old constraints have disappeared entirely. They haven’t. In order to stay one step ahead, the authorities already need to be thinking about what policies will be needed when the economy returns to normal.
Moreover, for their own sakes, investors, savers and mortgage-holders also need to be thinking now about the consequences for them once economic policy starts to tighten.
Roger Bootle is chairman of Capital Economics