Inflation is at the heart of the post-pandemic economic malaise running throughout the global economy. Inflation has surged to multi-decade highs prompting central banks to ramp up monetary tightening and set out plans to unwind outsized balance sheets.
In the UK, the Bank of England forecasts peak inflation will exceed 10% in the final quarter of this year (up from around 7% in February), and 8.7% in a separate estimate by the Office for Budget Responsibility (OBR) in March. In the US, annual CPI inflation soared to 8.5% in March, a four-decade high, and is forecast to remain elevated for months. In the eurozone, annual CPI inflation reached a new high watermark of 7.5% in April.
Central banks and governments point to the severe supply-side shocks caused by Covid-19, which created disruptions to supply (e.g. raw materials, commodities, food, energy, labour, etc.) and pushed up prices across the board. The duration of the pandemic and Russia’s war in Ukraine put further upward pressure on crude oil, commodities and fertilisers, while in the UK, a significant catalyst for inflation is the delayed impact of the April Ofgem price cap (and the anticipated October large increase). In a further macro complication, central banks are hiking interest rates into weakening economies, which in the case of the UK and the eurozone, are yet to fully recover from the pandemic. This combination of deteriorated growth and elevated inflation risks stagflation which ultimately lowers business investment and jobs growth while higher prices destroy demand, reducing growth further in a negative feedback loop. These causes, however, represent a far from a complete picture.
The inflation puzzle is twofold. First, the root causes are more complex and with a longer history than the commonplace narrative implies. Second, the generational high CPI inflation prints in the UK, eurozone and the US only tell part of the story. Alarmingly, these figures probably underestimate real inflation. Economists measure inflation based on the average price changes over time for a weighted basket of goods and services. The composition of the basket, and the weightings, are dynamic to keep pace with evolving consumer trends. However, this methodology does not capture the impact of money printing, or quantitative easing (QE), on the purchasing power of fiat currency. Therefore, the root causes and scale of the inflation problem are both broader and larger.
The current inflationary environment is the result of the interaction of successive negative external shocks to the global economy (e.g. the global financial crisis in 2008, Covid-19, and Russia’s invasion of Ukraine) and the monetary and fiscal responses over time (e.g. money printing due to quantitative easing and fiscal stimulus). Inflation is a pernicious – and partly obscured – long-term problem which is both accelerating and global. In this article, we will try to shed some light on the obscured relationship between inflation and money printing.
Money printing parabola
In the aftermath of the global financial crisis (GFC) in 2008 central banks pivoted to an ultra-expansive monetary policy posture to stabilise the deeply interconnected global financial sector, which at the time was teetering on the brink of collapse. Central banks took extraordinary steps to save the financial industry and the global economy by methods which have been normalised over the subsequent 15 years. It was to print money by crediting reserves to private banks which used the capital to finance the purchase of government bonds. The liabilities are held on central banks’ balance sheets, arbitrarily increasing the global money supply in circulation on a vast scale.
In January 2008, the Federal Reserve’s balance sheet was a modest $880 billion. Twelve months later, the Fed’s balance sheet had more than doubled to $2.1 billion and then more than doubled again to $4.5 billion by January 2015. That is a fivefold increase in seven years. As the global economy recovered from the GFC, the Fed managed to briefly reduce its balance sheet by almost one-fifth (17.7%) to $3.7 billion in September 2019, immediately before the emergence of Covid-19. In less than two years the Fed’s supercharged money printing – to support the US economy’s response to the pandemic – almost doubled its balance sheet, soaring to $7.2 billion by June 2020 and since then has climbed steadily to a whisker under $9 trillion today.
The growth of the BoE’s balance sheet tells a similar story. At the end of 2007, the BoE’s balance sheet was £77.7 billion, which spiked to £98.5 billion in 2008, and to £167.3 billion in 2009, before stabilising for three years at around £400 billion in 2013. Subsequently, the BoE’s balance sheet reached £607 billion in 2019 and £894 billion in 2020, to almost £1 trillion today. That equates to a 12.8-fold increase in the money supply of the pound in 15 years due to money printing.
Money printing and inflation
History shows us that continuous money printing is inherently inflationary and can lead to hyperinflation (e.g. Weimar Republic in the 1920s). However, for many years after the GFC-inspired first wave of money printing, inflation was persistently low across most major global economies. This enduring anomaly cast doubt over the centuries-old thesis on the relationship between inflation and money printing: the quantity theory of money (QTM). It posits that changes in the value of money are chiefly determined by the quantity of money in circulation. In sum, the greater the money supply, the lower the purchasing power of money and vice versa. For several years, it looked to many that the classic economic doctrine – which dates back to French philosopher Jean Bodin in the mid-16th century and was revised and refined by John Locke and David Hume – no longer applied. Many believed the data showed that money printing was no longer causally related to inflation, that QTM was antiquated, and we were now in a new economic environment. One popular explanation for this breakdown was the powerful disinflationary effects of technology across the global economy.
And then the pandemic-era money printing happened. The world retreated into lockdown, causing persistent supply-side shortages, which triggered broad-based price rises and inflation to roar back. Two years on from the start of the pandemic, the idea that money printing and inflation are not linked is no longer a credible position to maintain. However, it is possible that technology’s disinflationary forces delayed the onset of inflation. Russia’s war in Ukraine poured further fuel on the inflation fire. Money printing distorts financial markets, inflates asset prices and erodes the value of fiat currency.
The great unwind
Central banks are now starting to reverse QE and raise interest rates, reducing the artificial liquidity that has sustained global growth across western economies. Some suggest this great unwind will reverse fiat currency depreciation, as outlined above. However, there is a real possibility that it is already too late to extricate the effects of money printing on the real purchasing power of cash.
Last week, the Fed raised the fund rate by 50 basis points to between 0.75% and 1% and outlined plans to reduce Treasury securities by $30 billion per month for three months and by $60 billion per month thereafter. The BoE raised the Base Rate by a further 25 basis points to 1% and confirmed it will outline a gradual UK government bonds sales programme in August. The European Central Bank (ECB) is expected to reverse eight years of negative interest rates in July, but remains uncommitted on an asset tapering timeline. The politics of inflation in the eurozone is interwoven with Europe’s dependence on Russian energy and the European Union’s unified response to the invasion of Ukraine. China’s severe battle with Covid further threatens to delay the normalising supply chains and weakens export capacity and import demand with Europe and the US.
All three central banks are hiking interest rates into slowing economies as data implies the risk of a recession is increasing. In recent weeks, markets on both sides of the Atlantic have seen bonds and equities sell-off as they adjust to a new era of monetary tightening. However, a deteriorating economic outlook will test central bankers’ conviction to tame inflation through tightening monetary policy. Therefore, while we have reached the end of the second wave of money printing, it is by no means certain that QE is a permanently retired central bank policy. Arguably, central banks are trapped in a longer-term cycle of turning on and off QE taps to manage successive negative shocks to major economies.
Unsustainable debt to GDP ratio
Management of excessive government debt to GDP ratios may be a catalyst for a return to money printing. Government debt in most major world economies were already high coming before the pandemic hit, but government borrowing support public health, corporates and households has increase debt to GDP further. In the UK, public sector net debt (PSND) stood at 96.2% of GDP in the 2021-22 financial year. In the US, debt to GDP was 137.2% at the end of 2021. According to the IMF, increased debt to GDP ratios can be effective in the short-term to boost growth, but this fiscal stimulus benefit risks being partly (or fully) negated by the long-term impacts of increased debt to GDP ratio, which can slow economic recovery. There is also a risk – above a certain threshold – that economies descend into spiral of perpetual money printing to sustain public spending demands.
Fifteen years of money printing has severely reduced the purchasing power of fiat currency. It is a problem unlikely to be solved by the great unwind of central banks’ balance sheets (however far they manage to get before they are forced into a pause in asset tapering or another reversal). Historically, investors have flocked to gold when fiat currencies are weak. Increasingly crypto assets – such as Bitcoin – are emerging as a viable alternative. Bitcoin, like equities, has suffered heavy losses this year, but this should not obscure the macro outlook for crypto assets over the coming decades. Fiat devaluation is a problem unlikely solved by the great unwind of central banks’ balance sheets (however far they manage to get before they are forced into a pause in asset tapering or another reversal). By contrast, Bitcoin is a solution.
In the last three years, global markets have faced two unforeseen major global negative shocks – Covid-19 and Russia’s invasion of Ukraine. How central banks respond to the next unforeseen shock, whenever that comes, will be telling about the attention they are paying to the consequences of money printing and the devaluation of fiat currency. Fiat currency devaluation is a long-term structural problem for everyone – governments, global intuitions responsible for the financial stability, corporates and households. But the scale of the problem still remains obscured to many for now.