09.03.2021 - Comments

Inflation narratives will determine the fate of the central banks

by Pablo Duarte

“Inflation is temporary and central banks have it under control” Vs. “As central banks have massively increased money supply inflation is around the corner”. The fate of central banks will depend on which narrative will win.

The topic of inflation has made a strong comeback in past weeks. The main concern has been whether recent increases in consumer prices (such us in the Eurozone in December and in Germany in January), and rising measures of inflation expectations (i.e., breakeven inflation) are just a temporary phenomenon or the first signs of sustained inflationary dynamics. While some economists see deflation as the real danger, others point at the massive expansion in money supply and the steady rise in asset prices as signs of an increasing likelihood of sustained consumer price inflation. Will inflation reappear? Answers have come mainly from two different lines of narratives.

The “output-gap” narrative

Especially predominant in academic discussions and central banks, the output-gap narrative is based on the view that in recessions, aggressive monetary and fiscal stimulus can increase aggregate demand and push GDP back to its potential, i.e close the “output-gap”. Potential GDP is an estimation of the level of output that would be reached if labor and capital would be employed at their maximum sustainable rates. Inflation, according to this view, would increase if policies would raise aggregate demand “too much”, pushing GDP above its potential. However, there is no reason to worry because, in the narrative, central banks are seen to be able to bring inflation down by tightening monetary policy without endangering economic recovery. As long as inflation expectations remain anchored, the bigger risk is that real GDP does not return to its potential and deflation (not inflation) appears. Currently, real GDP in the US and the Eurozone are far below their officially estimated potential levels and therefore, in the output-gap narrative, deflation is the bigger risk.

Among those who believe in the output-gap narrative, discussions have recently circled around the question whether fiscal stimuli are too small or big. Former Treasury Secretary Larry Summers, for example, expressed worries that the USD 1.9 trillion pandemic relief package in the US might push US real GDP above its potential and cause inflationary pressures. Olivier Blanchard, a former IMF chief economist, has voiced similar concerns. Nobel Laureate Paul Krugman, in contrast, beliefs that pandemic relief cannot be compared to a traditional fiscal stimulus package. The output-gap would be an inappropriate guide for the assessment of catastrophe relief measures, which should be focused on health policy.

The central banks’ ability to fine-tune inflation is a key building block in the output-gap narrative. Although they have missed their inflation targets for many years, central banks remain confident that they can address inflation overshoots. Rising inflation would simply indicate that the cyclically adjusted natural rate of interest had increased. Policy rates would simply follow without creating tensions. Moreover, since inflation was below the target for many years, there was now room to make up for previous undershoots. Thus, the US Federal Reserve has announced that it will tolerate inflation rates above the 2% target for undetermined periods of time. ECB President Christine Lagarde said that “…it’s going to be a while before we worry about inflation”; and the president of the German Bundesbank Jens Weidmann said the priority right now is to “combat the pandemic’s economic impact”.

The “monetarist” narrative of inflation

In the “monetarist” view higher inflation is the result of higher money supply growth. The big rise in money aggregates has therefore led to concerns about increasing inflation risks.

The liquid money supply (money with zero maturity, MZM) in the US has increased 30% since January 2020 and the money aggregate M1 (sum of currency in circulation and overnight deposits) has increased 15% in the Euro Area (Figure 2). The increase has not been matched by a comparable increase in demand, which has been depressed by government-induced lockdowns. A part of the monetary liquidity has raised the demand for assets and boosted asset prices. When the pandemic subsides and people return to their normal lives, demand for goods and services is expected to pick up. Supply of goods and services would need to increase as much as spending, or central banks would need to withdraw excess money balances if they did not want to see “too much” money seeking “too few” goods. As economist Larry White explains, central banks would need to be able to perfectly foresee the evolution of supply and demand to manage this process so that inflation remains stable.

Cato institute economist George Selgin has recently claimed that forecasts of higher US inflation ignored the decline in the velocity of money and money multiplier (ratio of broad money to bank reserves). However, while it is true that these ratios have declined on trend until the pandemic, the sharp drops that occurred since then hardly reflect changes in money demand and money creation by banks. They have resulted from central bank policy and will hardly be sustainable when the economy returns to normal.

Adherents to the monetarist narrative are not only skeptical of the central banks’ ability to fine-tune monetary policy but also of their political room for maneuver for monetary tightening when normal conditions return. Government debt massively increased during the pandemic while interest rates declined. This would not have been possible without monetary financing of government borrowing by the central banks. A mopping up of excess liquidity by the selling of central banks’ government bond holding would lead to a jump in interest rates. But higher interest rates would jeopardize the solvency of many borrowers, push asset price lower, and squeeze government budgets. Another financial crisis and recession would loom. Governments would be hardly likely to tolerate this. Hence, the path of least resistance could be rising inflation and interest rates capped at low levels by central banks. Markets are beginning to price in such a scenario (Figure 3).

Lessons from History: Fiscal Dominance and Inflation

Historical evidence shows that “fiscal deficits that are financed by monetary expansion tend to be inflationary” (Bordo & Levy, 2021). Indeed, in all peacetime scenarios of inflation and fiscal expansion in advanced economies of the last two centuries, sustained government debt has exerted pressure on central banks to follow inflationary monetary policies. Central banks have been under “fiscal dominance”.

With stagnant growth, fiscal concessions to one interest group motivates other groups to seek concessions as well. Granting concessions, as Hirschman (1985) concluded from the Latin American experiences, is inflationary and ends up washing away the fiscal benefits the interest groups fought for. The US and to a greater extent the Eurozone have barely recovered from the downturn in 2020. Without growth and with the generous social compensation programs financed with central bank money, interest groups could seek even more comprehensive compensations in the form of wage increases. It is unlikely that central banks would be able to counteract the resulting inflationary pressures. Andy Haldane, chief economist at the Bank of England, recently quoted F.A. Hayek’s comparison of inflation control with catching a tiger by its tail. Governments and central banks are unlikely to be up to this trick.


Bordo, M. D., & Levy, M. D. (2021). Do enlarged fiscal deficits cause inflation? The historical record. Economic Affairs, 41(1), 59-83.

Hirschman, A. (1985). Reflections on the Latin American experience. The politics of inflation and economic stagnation, 53-77.

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