This blog was also published in an abridged form in Kathimerini's Money Review.
It will take time to achieve widespread vaccination coverage. Many rich countries might do it this year, but the poorer will likely have to wait until at least 2023. So, it will be another two years before a full exit from the global pandemic crisis.
The chances are that the state will continue to play a big role in the economy. Fiscal support will continue to need to be sizeable and sustained. This brings risks and the exact calibration of the size of this support is extremely difficult when uncertainty is high. Also, the role of fiscal policy in crisis circumstances is to provide support to households and firms so they can weather the storm, rather than to stimulate the economy by providing incentives for growth. This means that support should be designed based on social and cohesion criteria rather than strictly economic criteria. Nevertheless, there will be economic consequences, which must be assessed and managed.
The current debate about the US stimulus is an interesting case in terms of inflation risks. The Biden administration has announced a $1.9 trillion economic rescue package for 2021, equivalent to just below 9% of GDP. This is very similar to the immediate US fiscal response in 2020 (at 9.1%), but smaller than the total response made available in 2020 (allowing for deferrals and other measures including liquidity and guarantees), which amounted to 14.3% of GDP. The effect on inflation that a second fiscal support package will have has provoked deep and significant disagreements about whether such support will be inflationary (a very good summary of the debate is here).
The argument over whether or not support will be inflationary turns on macroeconomic variables that are very difficult to estimate during uncertain times, let alone in times of substantial structural change. Rather than concentrating on whether the shock is inflationary or not, given the very high level of uncertainty, it would be better to understand what it would mean if it did end up causing high inflation.
If inflation were to pick up, the Fed might not want to interfere for two reasons. First, the package is aimed mainly at consumption not investment and is temporary in nature. Inflation should therefore level out as the support measures fade out. Second, the recent change in the Fed’s strategy to average inflation targeting means that the Fed will tolerate inflation above target of 2% for much longer. We do not know how much longer that is but Figure 1 shows that inflation has been below 2% pretty much since 2012, equivalent to one business cycle in duration. The Fed therefore has the space to tolerate inflation above 2%, either for a prolonged period if inflation overshoots by small amounts, or for a short period if it overshoots by large amounts.
Figure 1: Personal consumption expenditures inflation, US
But what do markets believe? Figure 2 plots inflation expectations derived from inflation zero-coupon swaps of different terms.
Figure 2: US inflation expectations
The red line in Figure 2 is what markets thought about future inflation in January 2020. The blue line shows expectations as of May 2020, and the yellow line is the most recent (expectations as of 9 February 2021). A clear jump can be seen (by comparison to what markets believed in May 2020) not only in the short term but also permanently. Markets expect that inflation will reach 2% in two years and hover just above it for the next decade. This is consistent with the argument of anchored expectations.
What can be concluded from these disagreements about the consequences for inflation? One way of establishing the prevalence of uncertainty is exactly from the depth of these disagreements. One extra parameter to consider is that markets act according to their beliefs shown in Figure 2. Their views will affect their own profits and will influence the inflation outcome. Based on these numbers, inflationary risks are still subdued and it seems unlikely the Fed will feel compelled to intervene.
But what about the euro area? Should euro-area countries also continue to provide fiscal support? And what can be gleaned from inflation expectations? Are there any immediate inflationary risks that might require the European Central Bank to change course?
There are reasons to think there might be a temporary increase in euro-area inflation in 2021, primarily because of increases in energy prices and taxes (VAT in Germany). And indeed, this can be seen in the inflation expectations as well (Figure 3).
Figure 3: Euro-area inflation expectations
A big jump can be seen in inflation for this year, with a peak in 2022 (for which point the revision from May 2020 is over 100 bps). However, this increase is temporary. Inflation is expected to drop one year after that, only to gradually level off at 1.5% over the next 10 years. Inflation risks in the euro area appear to have subsided. We can expect no ECB policy change based on these numbers.
However, it is unclear if markets have priced in the effects of possible future fiscal support and concluded that it will have no inflationary impact. If they have not, future support may still have an inflationary impact, if announced.
For the moment inflationary risks seem small. There are two reasons however, why inflationary risks would be of greater significance for the euro area than the US, were they to materialise.
First, an increase in inflation could put the ECB in an awkward position. Inflationary pressures would require putting a stop to quantitative easing and an increase in policy rates. The ECB has a crucial role to play in enabling euro-area sovereigns to borrow in order to finance spending. This role could be jeopardised if its price-stability objective was pitted against its desire to help sovereigns access affordable financing, known as financial fragmentation.
The proportionality of ECB policies has been challenged by the German constitutional court, setting a dangerous precedent. If inflation were to re-emerge but the ECB did not change its policy course fearing financial fragmentation, there might be pressure to challenge it again, which would imply a big hit to the ECB’s reputation and ability to achieve its objectives.
Markets do not think the large recent fiscal support in the US will have an inflationary impact. In the euro area, inflation is expected to pick up this year for reasons that are short-lived and have to do with the reversal of deflationary factors. There have been no recent announcements of fiscal support in the euro area and there is no reason to believe that inflationary risks are material.
Demertzis, M. (2021) ‘Continuing fiscal support and the risk of inflation’, Bruegel Blog, 17 February