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Pandemic is defining duel of conflicting economic models

Ambrose Evans-Pritchard
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The US Federal Reserve is pouring high-octane jet fuel on a bed of dry tinder. So are the rest of the G10 central banks.

All it will take is the spark of post-Covid recovery to set off an inflamatory asset boom, followed by a surge in consumer price inflation in 2021 and beyond as the delayed effect of so much latent monetary stimulus flows through the economy.

That is the ever more vocal verdict of the monetarist fraternity on both sides of the Atlantic. They are at intellectual daggers drawn with the New Keynesian establishment in charge of economic policy in most the OECD states.

“Central banks are worried about deflation: my worry is that we are heading for double-digit inflation, particularly in the US where the surge in money has been most extreme,” said Professor Tim Congdon, from the Institute of International Monetary Research.

“This is nothing like the period after 2008 when the banking system was crippled and we needed QE just to stop the money supply contracting. I don’t know what the sequence will be over the next few quarters but the crushing evidence of monetary history is that the stimulus is going to be inflationary in the end,” he said.

Simon Ward from Janus Henderson said rising bank deposits amount to a coiled spring of pent-up spending and investment, waiting to flood the economy once confidence returns.

“All measures of the money supply are exploding right now,” he said. “We are going to have too much money chasing too few goods, and too few assets. A lot of this is going to flow into the markets at first. A year or too later, we’ll see inflation.”

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The implicit reproach is that global authorities have overreacted to the pandemic and that central bankers are by now political captives, bound and gagged. Monetarists say the sheer scale of QE and fiscal stimulus - now fused together in outright “fiscal dominance” - will overwhelm the economic costs of the Covid shock under any plausible scenario.

Prof Congdon said the broad money supply in the US is growing at the fastest rate in recorded peace-time history. There were episodes of such explosive inflationary financing during the American Revolution in the 1770s and in Confederacy during the Civil War. But nothing like this has been seen before in modern times.

The growth rate of “reconstructed” M3 (the Fed no longer tracks the data) has been running at an annualised rate of 80pc since mid-March. It has been less extreme in the eurozone, the UK, and Japan but it is still unprecedented in the post-War era.

Prof Congdon said the stimulus is likely to keep flowing as the US election nears. House Democrats are proposing a further $6,000 cheque for households, costing another $3 trillion.

Mr Ward said critics dismiss the monetary signals on the grounds that the effect is being offset by a commensurate fall in the velocity of money, in a sense rendering it inert. “But that is only happening because people are in lockdown,” he said. “Once they are out they are going to start spending again.

“Velocity will rise again but the monetary creation will almost certainly prove permanent. Does anybody believe that the current crop of ‘independent’ central bankers will be prepared to reverse QE as the crisis starts to abate?”

Michale Darda from MKM Partners says emergency relief - the CARES Act - lifted personal income by a staggering $2 trillion in April. This preemptive stimulus is sitting in people’s bank accounts. The household savings rate has exploded to an all-time high of 33pc.

This contrasts with the Great Depression when the savings rate was negative and people had depleted their reserves. “Against this foliage, we believe the foundation is in place for a ‘sooner and stronger’ recovery,” he said.

Chetan Ahya from Morgan Stanley says a “deep V-shaped” rebound is already picking up speed as fiscal stimulus begins to hit in earnest, with budget deficits exploding to 24pc of GDP in the US, 14pc in Japan, and 15pc in China (augmented deficit). The bank is now avowedly bullish. So is Goldman Sachs.

The counter-view at the Fed is that the Covid-19 shock will do lasting structural damage. It will take several years for firms to rebuild their balance sheets, and for new jobs to replace those that have been permanently lost. “The Covid-19 shock is going to be disinflationary, not inflationary,” said Richard Clarida, the Fed’s top strategist.

Chairman Jay Powell fears that the virus will keep flaring up or escape control again, causing the economic downturn to metastasize into something more dangerous. “I think a second wave would really undermine public confidence,” he said.

Unlike the Second World War, the pandemic has not destroyed global industrial and economic plants, and therefore has not destroyed the supply capacity. But it has destroyed global demand to some degree. It has forced companies and small businesses to take on extra debt merely in order to survive. That debt has to be repaid. In that respect it is akin to a slow-burning balance-sheet recession.

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The bond markets are in the deflation camp. They are sending a very different signal to exuberant stock markets. The rate on benchmark 10-year inflation-protected security (TIPS) has collapsed to minus 0.48pc. The yields have not recovered along with Wall Street since the March lows. They are not “confirming” the recovery at all.

Olivier Blanchard, former chief economist at the International Monetary Fund, said people are going to hold onto their precautionary savings for a long time for fear of losing their jobs. Firms must lick their wounds across decimated sectors. There is not going to be a surge in Capex investment because there is nothing to be rebuilt. Even more fiscal and monetary disaster relief will be needed, not less.

Two huge forces have collided. An unprecedented shock has been met with an unprecedented stimulus. Which of the two prevails depends on how the pandemic now unfolds.

If the lockdown is “one-and-done”, the monetarists and the optimists will claim their prize. If it is a messy sequence of failed exits and fresh outbreaks, the recessionary effects will take on a different character and will probably precipitate a debt crisis.

For monetarists and New Keynesians - no great friends at the best of times - it is the defining duel of two completely different and incompatible models of how the economy works. This journalist is not taking sides. I will happily hold their coats.