NRPLUS MEMBER ARTICLE I n April the Consumer Price Index (CPI) had its greatest one-month decline on record, with year-over-year inflation falling to 0.38 percent (core inflation, which excludes food and energy, fell to 1.4 percent). Wall Street predicts that inflation will remain subdued below the Fed’s 2 percent target for some time to come, as the break-even interest rate on U.S. Treasury Inflation Protected Securities (TIPS) shows that markets expect inflation to roughly average 0.8 percent over the next five years.
Online inflation as measured by the MIT Billion Prices Project/PriceStats, which tracks prices in real time on a daily basis on websites such as Amazon.com, has continued to fall throughout the month of May, even going slightly negative (implying some deflation).
How can such disinflation be possible, given that the Federal Reserve has expanded its balance sheet by trillions of dollars over just the past few weeks, and that the coronavirus has distorted global supply chains, causing shortages? Either one of these events might be expected to trigger inflation, yet the reverse has occurred.
The answer is that the coronavirus stay-at-home orders are overwhelming any possible boost to demand generated by the Fed’s current monetary-policy regime. A secondary cause is that Russia and Saudi Arabia were locked in an oil-price war in March, refusing to cut production, and this brought energy prices down and many inputs into inflation down with them.
Furthermore, the coronavirus supply shocks are nothing like the supply shocks seen in the 1970s, in which the higher oil prices generated by OPEC supply cuts boosted inflation both near the beginning and at the end of the decade, adding fuel to a fire that was already burning thanks to the deficit spending that flowed from the Vietnam War and the Great Society. That the Fed, in those pre-Volcker days, was headed by the accommodative Arthur Burns only made things worse.
A new paper by macroeconomists Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Ivan Werning illustrates how pandemic-induced supply-side shortages can induce demand shortages and corresponding deflation through shutting down entire sectors of the economy (such as restaurants and hotels). In turn, this can hit demand for related sectors (such as luggage and attire). This contrasts with more “traditional” supply shocks (such as those in the 1970s), which affected all sectors more evenly and — despite the spectacle of lines at the gas pumps in the 1970s — kept most products still generally available, albeit at a higher price.
To be sure, some components of inflation, such as food prices, are likely to see substantial increases as supply chains continue to be disrupted by sporadic coronavirus outbreaks at meat-packing plants and occasional runs on grocery stores. In the months following the coronavirus outbreaks in China and Europe, food prices spiked, according to inflation data in the countries concerned. These supply shortages will be short-term blips unlikely to make much difference to the overall inflationary picture.
Getting back to monetary policy, the Fed is indeed entering relatively uncharted territory in buying corporate bonds — sending their prices back up and yields downward, making it easier for corporations to borrow. Would such quantitative easing be inflationary? Not very likely. Over the past ten years, trillions of dollars of Fed asset purchases of securities have been funded by excess bank reserves, and the last decade is not exactly one that has been marked by inflation, at least as conventionally measured (asset-price inflation may be a different matter).
The reason for this is twofold. First, the Fed takes the Treasury bonds it buys out of the system; that was expected. What was not expected was that private banks would put their money in excess reserves rather than creating new loans (which was the original intent of QE). If central banks were to issue new legal-tender currency to finance asset purchases rather than excess reserves, this would be highly inflationary, as it would actually create new permanent money, which would flow from the banking system into the “real” economy, as opposed to temporary reserves, which do not.
To be sure, it is also possible that banks may feel incentivized to lend more by the Fed’s new Main Street lending programs (which provide some level of loan guarantees to banks). In theory, that could be inflationary, although it is hard to believe that this will overpower the negative shocks to confidence brought on by the shutdown. And in such a pessimistic environment, it is reasonable to ask how much new money the banks will actually lend.
But it’s too soon to dismiss inflation altogether. Monetary policy has “long and variable lags,” as Milton Friedman famously put it. A 2005 study by Northwestern economists Larry Christiano and Martin Eichenbaum and Chicago Fed president Charlie Evans shows that it takes about three quarters for monetary policy to work its way through the economy. Also, one-year forward-looking consumer-inflation expectations have risen to 3 percent as of May, according to the University of Michigan Consumer Sentiment Surveys (five-year forward-looking consumer-inflation expectations have risen to 2.6 percent). Prices may be starting to bottom as well as indicated by the above online price data from the MIT Billion Prices Project/PriceStats.
We’ll have to wait some time to see how these opposing shocks to demand all play out with stay-at-home orders on the one hand and easy monetary policy on the other. In the short run, I would expect more disinflation.