These days, I am often asked whether we can expect a sudden rise of – global – inflation within relatively short notice. This question is not only being asked by investors, bankers, economists or other people ‘close to the fire’ but also by ordinary folks. People that do not have a clue what to do with their savings which are melting away as a result of the negative interest rate policies of central banks all over the world.
As usual, a straight and precise answer to this question is simply impossible. Economics is not an exact science – some even doubt it is a science in the first place – and economists certainly do not have a crystal ball. My answer usually is that we do not know, however adding that there are enough reasons to worry. Especially in the Eurozone.
Let’s take a look at the arguments of those that are not afraid of increasing inflation. They argue that as a result of technological, global and demographic developments, there is downward pressure on prices. And they are right about that.
However, there is a lot more to it. We are living in an over-indebted world. Central Banks all over the world have activated the money printing press.
Particularly in the Eurozone, the monetary base, or the cash-holding coefficient, has increased to a whopping 43 percent of GDP. That is almost twice the level of the US, where it is 24 percent. In 2008, at the start of the Great Financial Crisis, that figure was ‘only’ 12 percent in the Eurozone. Therefore, today, the monetary base in the Eurozone is 3.5 times larger as compared to 2008.
For now, this liquidity surplus does not lead to inflation, due to the negative interest rate policies of the ECB. The commercial banks are sitting on a mountain of cash that is not entering the real economy. This situation is not without risk, which I’ll explain.
Furthermore, the global economy has been confronted with a pandemic of unheard proportions, hitting the whole world economy in the first half of 2020, and a full recovery is not expected soon. Certainly in the Eurozone, that will take time. However, according to expectations, demand is bound to go up enormously once Covid vaccination administration has been completed and ‘normal life’ is allowed to restart. Economists therefore expect an ‘orgy’ of consumption, maybe already at the end of 2021, but certainly in the upcoming years.
Meanwhile, the ECB is continuing its “Pandemic emergency purchase programme” (PEPP) as well as its “usual” bonds purchasing programs. Billions of freshly printed euros serve to lower the yields of government bonds in the Eurozone. On top of that, the European Commission will be acting as a new issuer of debt, with the “NextGenerationEU fund”. The latter will lead to another 800 billion euro and more being injected into the markets.
Hence, instead of reducing government debt in the Eurozone, it is being increased. That is not a good idea, not only because most governments lack the competence to spend the money well, but also because it does not solve the real problem, which is that the economy is drowning in debt. Because debt levels are so high, it is very difficult to implement the interest rates hikes needed to counter inflation, as public finances may be troubled.
The metaphor of the “ketchup bottle” can serve to illustrate inflation dynamics. As the central bank keeps shaking the ketchup bottle – i.e. monetising debt – no ketchup – i.e. inflation – comes out. In response, it shakes even harder. In the end, the ketchup does comes out, but in a wild, inflationary rush.
Nobody can predict when this will happen, but it is also not possible to predict with certainty that it will not happen. So, given the possibility that it can happen, one should prepare for a worst case scenario, right? That is rational thinking and prudent monetary policy.
What do you suppose is going to happen to the balance sheets of commercial banks if inflation takes off? What effect will it have on the value of their assets and investments, like government bonds? Indeed, they will need to book huge depreciation losses. Are European banks really solid enough to absorb those losses? And what do you think is going to happen to the over-indebted Mediterranean member states? Inflation may help to erode their debt, but is this good for the Eurozone as a whole? Mediterranean member states may no longer be able to refinance their huge debt. Inflation would also harm Northern European savers and pension funds in a severe way. Their purchasing power will diminish, and thereby their ability to buy Mediterranean government bonds.
The ECB’s policies are borderline monetary madness. This in particular because the ECB is really driving a car that lacks brakes, because it is no longer able to employ its interest rate weapon in an effective manner. The result is that debt will only continue to increase and that it will become unsustainable at some point. Frankfurt is truly caught in a stalemate.
In sum, if the expectations of long term overconsumption, which I deem very likely, become a reality, in combination with negative interest rate policies (NIRP) and enormous stimulus packages, engendered by both the ECB and the European Commission, it is more than likely that this will cause a sudden emergence of bank lending, contributing to a sudden increase of inflation, something which would hit savers and pensioners hard. In effect, commodities, food and industry producing prices are already rising. This is worrying, especially given that the ECB’s monetary tools to cool off this flood of liquidity are being constrained by fears that increased interest rates would threaten sovereign defaults in the Eurozone.