Arnab Das: Inflation is set to be contained in a tug-of war game between competing forces

At our recent webinar on inflation, John Greenwood, Arnab Das and David Millar gave an update on their latest thoughts on the subject. With markets showing increasing signs of anxiety that inflation is poised to move higher, possibly into unfamiliar territory, the debate was certainly timely and topical. The uncertain outlook was reflected in a broad range of views being offered by our speakers. Although a lot of ground was covered, the full schedule meant that John and Arnab were not given the opportunity to answer all the questions. A selection of these additional questions are answered by Arnab Das below.     

Arnab Das has a more benign view on the inflation outlook, arguing that major economic differences around the world point to varied growth rates. While he expects a tug-of-war between reflation on the reopening of economies versus lowflation forces, the recent rapid rise in M2 money supply has not driven inflation sharply up. He argues that the M2 surge reflects public and corporate debt issued to replace household income and corporate revenue in lockdown – not regular occurrences.

1. The Fed has widened its remit to include a more equal society. Will that mean that they have to apply wider inflation metrics going forward?

Concerns about the Fed’s mandate being extended to better income distribution, are linked to concerns about inflation risks and excessively loose fiscal policy.

In summary, the Fed seems more likely to allow inflation to run somewhat higher than its 2% target for the “Discretionary Core Personal Consumption Expenditure” index (Core PCE), rather than change its inflation metrics or inflation target, per se.

The Fed’s triple mandate¹ - full employment, price stability and moderate long-term interest rates - does seem to have been expanded along two further dimensions:

• to financial stability more formally after the Global Financial Crisis
• and to better outcomes in the labour market in the wake of relatively weak growth recoveries in the last two decades.

Financial stability will remain paramount, though the Fed seems unlikely to directly intervene or change monetary policy on the basis that asset prices are out of line with economic fundamentals, because that link is hard to make or sustain, especially without running the risk of undermining its other mandates.

Better outcomes, such as more equality in the distribution of income, cannot be directly achieved by the Fed - it is really a focus of fiscal and regulatory policy that are in the remit of Congress and independent regulators, rather than monetary policy.

What the Fed can do with monetary policy is ensure that unemployment is low, and perhaps lower than otherwise by running an easier monetary policy than it would using its traditional metrics for the relationship between unemployment and inflation.

This approach would be fit into the Fed’s new “Flexible Average Inflation Targeting” framework, in which the Fed plans to allow inflation to be somewhat above target for some time, in order to compensate for the last two and a half decades of below target inflation.

The Fed seems to believe that this period of “lowflation” has contributed to a deteriorating distribution of income, because wage inflation has been very low even when unemployment was very low - indeed below its own and other estimates of the non-inflationary floor for the unemployment rate.

2. Under Trump’s administration nearly US$4 trillion was printed. The Biden administration is now planning on a two-stage stimulus package: rescue and recovery. The “rescue” will be close to US$1.9 trillion. The “recovery” part, still being discussed, could be as large as US$3 trillion! The GDP of US is just over US$21 trillion. Who is going to fund all this debt?

In summary, the scale of US fiscal support is unprecedented in both absolute terms and as a share of GDP.

The repeated, large-scale programmes have become controversial politically, and are also raising concerns about excessive public borrowing with potentially inflationary impact in an economy that has already almost closed the gap with the pre-pandemic level of GDP.

Even so, there are very good reasons to think that increased US public spending and deficits can be financed with bonds in the near term, followed by increases in taxes over the long run, once recovery is well underway.

The key will be to maintain US economic dynamism and the incentives for innovation while improving the incentives for investment in education and training to upskill the US labour force and rejuvenate underperforming regions of the country.

Given the scale of the US economy, the depth of financial markets and the institutions of the state and society, we do not expect any major problems with financing these transitions.

Longer-term spending programmes including infrastructure and other build back better programmes are also in the offing.

The public policy case for enlarged government spending is strengthened by the challenges facing the US system - in a nutshell, environmental, social and governance challenges.

Inequality along socio-economic, gender and  race lines have become a major fault line in US politics and arguably require sustained, sizeable public spending on education, health and infrastructure as well as changes in the incentives for both firms and individuals to save more, invest more and think longer-term.

It does seem likely that the size of US public debt will be larger for longer than ever before in peacetime.

That said, major changes in the structure and role of the US government as well as major economic reforms are very difficult to push through quickly and extensively in the US system of checks and balances.

In particular, major reforms require bipartisan consensus to achieve the 60-seat supermajority required to avoid a filibuster that would prevent passage in the Senate - a threshold neither party seems likely to achieve in a polarised US system.

This political reality suggests that reforms will not only be gradual but also that they will not be too radical in super-sizing the state or imposing excessive regulation.

Accordingly, there doesn’t seem to be much concern in the markets about the funding of this debt - which seems is reasonable under the circumstances.

Private savings are elevated and the Federal Reserve’s (Fed) tapering programme continues.

The contribution of US public spending to growth is likely to support global growth at a time when the other two major economies - China and the Eurozone (EZ) - are providing much less policy support to drive global recovery.

The combination of easy Fed policy, a large budget deficit and faster US growth implies a larger current account deficit and a weaker dollar, which should both be supportive of global growth through easier global financial conditions than otherwise (through the soft dollar) and stronger US imports.

As a result, the US economy could once again become the leading driver of global growth at the margin, rather than China, at least for the post-pandemic recovery phase.

The policy mix also implies a potentially more attractive purchase price for US Treasuries and other US assets through both a higher yield and weaker dollar, for foreign investors.