This article appeared in The Bulletin Autumn 2020 published by OMFIF.

Juan Castañeda is Director and Tim Congdon is Chairman of the Institute of International Monetary Research.

The global policy response to Covid-19 has resulted in marked accelerations in money growth since March in the world’s leading economies, particularly the US.

Asset price inflation has already materialised. Consumer price inflation has not yet increased, but an inflationary process is likely to raise the price of goods and services. The rates of increase of money and nominal national income are linked over the medium and long run. Changes in real money growth affect asset prices and balance-sheet strength in the short run, and hence the economy’s cyclical path. This explains the signs of a rapid ‘V-shape’ recovery observed in recent weeks in the US and other major economies.

The ratio of cash to assets in market participants’ portfolios has increased significantly, for precautionary reasons. This is equivalent to a notable fall in money velocity. It explains why the recent increase in money growth has not been reflected in an increase in nominal demand and overall inflation. However, once the global economy recovers from the Covid-19 crisis, the velocity of circulation will return to more normal levels, reflecting the long-run stability of households’ and companies’ money-holding preferences. At this point, the accelerations in money growth which occurred in 2020 will probably be followed by similar accelerations in the growth of nominal national income. Given that the pandemic affected the world’s underlying productive capacity, much higher growth of nominal national income must lead to higher inflation.

Regrettably, central bankers mostly rely on non-monetary theories of inflation to question whether over the medium to long term, unduly rapid money growth causes inflation. The ‘inflation vs. deflation’ debate is certain to intensify. Last month, the Federal Reserve announced a new policy strategy (‘flexible average inflation targeting’). It signalled that it is prepared to allow consumer inflation to rise above 2% for certain periods of time in order to deliver a long-run average very close to 2%. Unfortunately, the Fed did not provide details on how it will implement this strategy. It seems that the Fed is giving itself greater room to run more discretionary (and inflationary) policies in the future if need be. However, if the annual rate of US money growth exceeds 20% for more than a few quarters, the Fed leadership may be surprised by how quickly inflation takes off into the sort of numbers that worried its predecessors in the 1970s-80s.