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The resurrection of inflation?

Lower inflation (and possibly deflation) in 2020 will be a consequence of Covid-19 from the shocks to aggregate supply and demand. However, paradoxically, the longer and deeper the economic crisis, the greater the probability of monetisation and helicopter money, leading to the resurrection of inflation in 2021-22.

The scale of the expansion in quantitative easing is not the only significant monetary policy shift since the onset of the Covid-19 crisis. Central banks such as the Bank of England and the Fed have indicated the possibility of monetisation i.e. a willingness to engage in even more extraordinary monetary policy and so-called ‘helicopter money’. Although it might be argued that in some sense ‘helicopter money’ has already been in existence for a decade because QE involves a central bank making direct payments to the private sector, and that in undertaking that QE and it isn’t then reversed, there is a permanent increase in the money supply.

Commenting on the potential for helicopter money, CEPR President Weder di Mauro was quoted in the Financial Times saying: “Things are moving very fast and minds are too”. Former Chairman of the Federal Reserve Ben Bernanke has argued that: “under certain extreme circumstances monetary financing of fiscal deficit spending may be the best available alternative”.

The original name helicopter money was coined by Milton Friedman in 1969, when he wrote a parable of the idea that central banks could print money and distribute it directly to individuals – thrown out of a helicopter. The idea has subsequently evolved into a slightly more formal approach, with it generally used to encompass the ‘permanent’ monetisation of budget deficits. 

Monetisation is the issue of whether the Bank of England should pay for HM Government’s fiscal stimulus directly, effectively printing money (in the direct market), or should borrow it in the usual way (through the secondary market). Monetisation would occur if the Bank of England bought gilts directly from the Government, in contrast to the operation of QE to date, where the purchases have been made in the secondary market from banks and pension funds etc. At present the Bank of England operates entirely in the secondary market when it undertakes quantitative easing.

The Great Financial Crisis led to extraordinary monetary policy in the form of massive ‘secondary’ quantitative easing. Could the Great Infection lead to even more extraordinary monetary policy with even greater ‘primary’ quantitative easing?

Thus far there is no sign whatsoever of the need for direct financing because gilt sales have been ‘covered’ i.e. the demand to purchase gilts has exceeded the amount offered for sale in the primary market. As Sky News Economics Editor Ed Conway pointed out in one broadcast, the reason the gilt auctions are covered is because there is, “a monster [the Bank of England]” waiting in the secondary market to buy them. But the longer and deeper the crisis the greater the issuance of public debt and the greater the pressure to monetise it if auctions become uncovered - in order to avoid a spike in gilt yields. In the worst case scenario higher inflation could become an object of policy in order to help reduce the real value of public and private debt. That would bring a very different meaning to the term 'inflation targeting'!