By Fabian Wintersberger, Rates Trader and Economist, based in Austria
When ECB chief economist Philip Lane was recently asked if inflation will last instead of being just transitory, his answer was pretty clear: “I really don’t see it. I just don’t see it.”
Several ECB members have insisted inflation would be “temporary”, including ECB president Christine Lagarde, who said so repeatedly. They basically employ two arguments for that:
The first argument is that the uptick in inflation during the last few months would be mainly due to base effects – low inflation in 2020, as a result of the pandemic – and because of demand returning as the economy reopens.
The second argument points to the labor market and that the unemployment rate is still above pre-pandemic levels in the European Union – 8.17% in Q2 2021 compared to 7.30% in Q1 2020. Many economists and analysts see this as a key factor why a low-inflationary – or even deflationary – environment is likely to persist. According to their line of thinking, only substantial wage growth would lead to higher, persisted inflation, and for that, there would need to be a tight labor market.
Additionally, there is also another claim often made by economists calling even more interventionist policies by governments and central banks: ‘Don’t listen to all those fear mongers that warn about returning inflation. They already said that right after the “Great Financial Crisis” of 2008. They were wrong then and they will be wrong now’.
Why the current situation is different than after 2008
It is correct that, after 2008, all that money creation by the ECB, implemented through lowering of interest rates and a variety of asset purchase programs, did not lead to sustainable inflation. So why was that? Why did an expansion of the ECBs balance sheet not cause inflation?
To understand this, it is important to explain the actual effect of the ECB’s bond buying programs. The ECB does not buy bonds at auction. It buys them from an investor instead – banks or other institutional investors or businesses. Summarized, the ECB pays the bondholder a price in euro. This amount of money replaces the bond on the balance sheet’s asset side of the investor. The ECB on the other hand expands its balance sheet, adding the bond on the asset side while creating cash-liabilities on the liabilities side.
As a result, the total amount of money within the “real economy”, different from the “financial economy”, where the ECB has enlarged the balance sheet, has barely changed. This explains how QE failed to engender all the “real economy” inflation so desperately sought by the ECB.
In any case, the main goal of these ECB programmes was to support banks by buying up their risky assets, so banks would be able to increase lending to the “real economy”. That did not happen, however, as shown by the Bloomberg chart below, which features the ECB Euro Area Monetary Financial Institutions Loans to Non-Financial Corporations:
Our financial system is designed to let money flow into the “real economy” through bank lending and, as we can observe in the chart above, lending by Eurozone banks to non-financial corporations did not recover after 2008 and collapsed during the European sovereign debt crisis. After that it barely recovered. As a result, inflation remained subdued.
What we can also see on the chart however, is that after the start of the pandemic in 2020, Eurozone bank lending rose sharply. Now, it is back to 2012 levels. The reason why this happened serves as the main counter-argument against the ECB’s narrative that the rise in inflation would be only transitory and that it will phase out once the economy has turned back to normal.
The entry of governments into the monetary environment
While the ECB was fully in charge of the money supply before the pandemic hit, as a result of the imposed shutdowns of the economy, governments have entered the monetary environment and have generously handed out loan guarantees.
This provides a direct incentive to banks to lend money to the “real economy”, given that they no longer bear the risk when things go wrong, as governments are now bearing that risk. As a result, banks can lend and do no longer have to worry whether a business is able to pay it back, because if the business is failing, the government steps in and repays it.
As Scottish market strategist Russel Napier, who has been warning for disinflation and deflation for two decades and is now warning for inflation, explained it in an interview with TheMarket.CH last year: “Governments have taken control of the money supply”. Looking at history, he thinks it is unlikely for governments to give this up after the end of the pandemic. As Nobel prize winning economist Milton Friedman once put it: “Nothing is more permanent than a temporary government program”.
Zombie companies are being propped up
Nevertheless, one could still argue that this will not necessarily lead to inflation if all that newly created money contributes to an increase in GDP – or put otherwise: an expansion in the quantity of goods produced. While that may be correct in theory, I doubt that this will be the outcome of this.
On the contrary, I think all those loan guarantees offered by governments will cause even more malinvestment than before. Flooding the system with newly created quantities of money has led to an increase in the number of so-called “zombie companies”, according to the ECB, and most of them have been eligible for loan guarantees.
If those businesses are kept alive with cheap money, output will continue to decline after a brief recovery resulting from the ‘grand reopening’. As more money is entering the system while that money is chasing fewer and fewer amounts of goods – given declined output- we’ll witness upward pressure on prices. In the end, again Milton Friedman (picture) said:
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Ongoing bottlenecks in supply chains and the effects of government lockdowns have already pushed commodity prices, food prices and other nonreplicable goods higher. People all over Europe are already experiencing much higher inflation than stated by the “Harmonised Index of Consumer Prices”, an indicator of inflation and price stability used by the ECB. Producer Prices are also increasing, which leaves corporations with only two options in the foreseeable future: increase prices or go out of business. Both options will only put more pressure on consumer prices.
Why the ECB cannot admit inflation is anything but transitory
At some point, investors may come to conclude that the ECB will never admit that the current increase in inflation will be anything but transitory. To claim it is transitory may be the only way for the ECB to try to keep the scheme alive, because if that is not the case, the ECB faces an even bigger problem: it could be forced to raise rates, something which may crush the recovery that has been fueled by easy money.
Given that Eurozone government debt is already close to 100 % to GDP on the one hand and that businesses and households are burdened with huge debt levels on the other, the ECB’s hands seem tied. Apart from the increased role governments now play in the monetary sphere, this is yet another reason why sustained inflation way above the ECB’s 2 % inflation target may not be as farfetched as many assume.
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