Inflation has been dormant in Western Europe for almost a quarter of a century. So it is natural to assume coronavirus will not change that. Indeed, the likely legacies of the pandemic – weak demand, high debt and low interest rates - could depress inflation further. But while the central case is for inflation to remain very low, there are upside risks to this scenario.

Europe’s economies could be witnessing a huge monetary and fiscal expansion against a backdrop of factors that might constrain productivity and aggregate supply. We might in time see ‘too much money and wealth chasing too few goods’ – Keynes’s classic characterisation of inflation.

COVID-19 has the potential to cause a large aggregate supply shock. Some businesses have had to reduce capacity; some will go bankrupt. Unemployed workers may lose their skills; spending patterns could change permanently. If potential supply is disrupted stimulus policies aimed at raising demand might eventually be inflationary.

The early 1970s illustrate the risks. Until then, policymakers assumed any rise in unemployment could be reduced with timely stimulus. But they made the mistake of ignoring the structural state of the economy. Loose policy and slowing productivity growth combined with sharp oil price rises ultimately resulted in double-digit inflation.

Then, as in the pre-pandemic years, labour costs were creeping up in Europe and productivity growth was sluggish while monetary policy was loose. In another parallel with the 1970s, bailouts could make the state a major stakeholder in businesses, resulting in them being run with political aims rather than maximising efficiency. And many factors that contributed to low inflation over past decades may now be waning. Trade wars, reshoring, nationalism, reduced immigration and geo-political tensions could potentially reverse the disinflationary forces of globalisation.

A decade ago, fears that quantitative easing would be inflationary proved false but the policy response to COVID-19 has sharply increased the broad money supply, and this time government borrowing is being transferred much more quickly to households and businesses. If spent, not saved, that money put could put upward pressure on prices as economies recover.

History shows that increases in public debt, the money supply and prices often go hand in hand. The fiscal actions seen across Europe mean public borrowing is ballooning – and interest rates may not always be low.

If central banks, wary of facing the wrath of governments by raising interest rates, wait for evidence of sustained higher inflation they risk leaving tightening too late. After years of undershooting inflation targets, a few years above target might seem acceptable. Indeed, a rise in inflation is likely to be widely welcomed at first. The US Fed has already modified its strategy. But as the 1970s demonstrate, once the inflationary genie is out the bottle, it can be very difficult to put back.

First published 7 September 2020.

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