Financial markets are concerned about ‘recession risk’, or so the newspapers tell us. When the world’s leading economies are viewed objectively, it would be hard to imagine circumstances in which recession was less likely. All recessions since the 1930s have begun with monetary policy tightening to curb inflation. This is true even of the 2008 � 2009 Greeat Recession, although officialdom’s reaction was disproportionate and misguided, and led to a few months of outright deflation. (Government, central banks and regulatory agencies imposed new regulations that acted like a punitive shock on banks, and stopped the growth of their balance sheets and hence of the bank deposits that constitute most of the quantity of money.) But today inflation in the leading economies (excluding India, and also such places as Russia and Brazil beset by corruption, political adventurism, misgovernment, etc.) is virtually zilch. The concern is not too much inflation, but the danger of deflation. In effect, there is no constraint on expansionary monetary policy. Objections to this argument are two-fold. The first is that in the United States of America the recovery is so mature that the labour market is showing signs of over-heating and a normalization of monetary policy (with higher interest rates) has become necessary. The weakness of this claim is that, although the unemployment rate has dropped to beneath long-run averages, many people have left the labour market temporarily because of lack of demand. The employment rate is still well below the 2008 level. Meanwhile the strong dollar is hurting manufacturing, reducing import costs (over and above the impact of low oil prices) and dampening inflation. Talk of four Fed rate rises in 2016 is starting to look very silly.
The financial crisis of late 2008 is at last being viewed analytically. Speeches from central bankers (for example, Lorenzo Smaghi of the ECB in a workshop at the Bank of Canada on 9th April) are asking
- what went wrong?, and
- what should have been done?
Worries about inflation are misplaced – indeed extraordinarily misplaced – in current conditions. Output is further beneath trend in the major advanced economies than at any time in the post-war period. Rising inflation will not return until after a global boom or an extended period of above-trend growth. Nevertheless, Mr. Alan Greenspan – the revered former chairman of the US Federal Reserve – published an article in the Financial Times of 26th June under the title ‘Inflation is the big threat to sustained recovery’. The argument of this note is that Greenspan is seeing ghosts. There is little or no risk of a significant rise in inflation until after – probably several quarters or even years after – output has returned to its trend level. The main point is simple (and is indeed much the same as in our weekly e-mail of 22nd May), that on average inflation has fallen during US recoveries. Just to reiterate the fundamental point being stated here, typically in the recovery phase of an American business cycle falls in inflation accompany above-trend growth. Within the space allotted by the Financial Times, Greenspan was hardly able to develop a meaningful economic model. He reported that, “annual price inflation in the US is significantly correlated (with a 3 ½ - year lag) with annual changes in money supply per unit of capacity”. If Greenspan were referring here to M2 or M3 per unit of output, his claim would be both understandable and backed by a large amount of evidence over many decades. But had he not noticed that so far in 2009 M2 growth has decelerated sharply compared with 2008? (See our weekly e-mail of 11th June on "US M2 – The Bernanke flip-flop".) Greenspan then highlighted the USA’s large budget deficit and the danger that it might be monetized, with eventual inflationary consequences. There are two problems with this argument.