High and persistent inflation has come as a surprise for many. The US Federal Reserve famously labelled inflation ‘transitory’ in early 2021, and for months stuck to the line that price rises simply were the result of a one-time shock due to bottlenecks as the world economy re-opened after Covid lockdowns. As prices continued higher, they kept redefining what was meant by ‘transitory’ until the Ukraine war conveniently provided a cover for their forecasting failure when they were able to blame broad price inflation on more expensive energy and food as a result of the conflict. Central bankers are now being called out for their failure to foresee what was happening and their complacency in reigning in their extremely expansive monetary policies.
But central bankers were hardly alone in getting inflation expectations horribly wrong. Realised inflation has proven much higher than expected inflation as derived from the inflation swap market. In other words, financial markets have persistently underestimated how high inflation would become. The below graph shows the market expectations of inflation 9 months forward and the actual level of realised inflation 9 months later for USD and EUR (the picture is the same in other currencies like GBP). From the beginning of 2021, when price rises began to materialize, market participants have been playing catch-up, persistently getting their forecasts wildly wrong to the downside.
This should come as no surprise. Steeped in Keynesian economic theory, central bankers, academics, market economists and commentators have relied on a fundamentally flawed idea about what drives inflation. According to Keynesian economics, inflation can broadly arise from three sources. Demand-Pull inflation is caused by increases in aggregate demand. Cost-Push inflation occurs when one-time shocks, such as supply chain bottlenecks, impacts aggregate supply. Finally, as expectations of inflation takes hold, inflation becomes a feature of the economy, most famously via the so-called wage-price spiral (which is actually not inflationary at all, as we explain here). The narrative is that inflation so far has been caused by the former two, leading to central bank complacency and ridiculous soundbites like President Biden’s ‘Putin’s price hike’. The latter now poses a risk of persistent inflation, the story goes. The abject failure to predict the current inflation has predictably led to no mea-culpa from the dominant Keynesian community.
There are, of course, those who saw this all coming. In fact, monetarists and Austrian economists have, far from underestimating inflation since 2021, struggled to explain the absence of inflation during the era of Quantitative Easing, the monetary policy pursued by global central banks since 2008 where newly issued government debt has been bought by central banks using freshly printed money (technically bank reserves). According to this school of thought, price inflation is caused solely by an increase in the money supply. And while QE caused a rapid increase in the M1 money supply after 2008, the unprecedented measures introduced to finance the Covid lockdowns have, as the graph below shows, caused what can only be described as an explosion.
Looking at this graph, high inflation should have come as no surprise – and for some it didn’t. High profile Austrians like Peter Shiff and Bob Murphy called it and they were not alone – we pointed out in July 2021 that the Federal Reserve’s expectations that inflation would be ‘transitory’ would be proven wrong. But if the theory is right, why has inflation taken so long to manifest if QE started well over a decade ago? The likely explanation is to be found in the deleveraging of commercial banks, as we explain here.
Rising interest rates and an end to QE (possibly even Quantitative Tightening) will eventually cause the money supply to stabilise or even contract – if so, we might face a period of deflation. But before then we will need to contend with the effects of past mistakes. Inflation will destroy the purchasing power of ordinary people and induce a serious recession as years of capital misallocation is exposed but despite what Keynesians in the central banks believe this will not quell inflation. As the larger money supply diffuses through the economy, prices will continue to rise for some time yet. Dark times are coming.