US economic policy is now highly inflationary. In a US$-based financial system this implies rising global interest rates. UK inflation and interest rates will increase too. This need not derail the coming UK economic recovery but will require gradually more restrictive fiscal and monetary policies, a free trade drive, and supply-side reforms. These are major policy challenges, but the early signs are encouraging. The structurally impaired EU is much more at risk.
Early signs of higher global inflation are already appearing. The CRB commodity index has risen by 35% since the US Presidential election, and 70% since its low in May 2020. Shipping costs have increased sharply. Consumer and investor inflation expectations have notably rebounded. In response the key global interest rate – the US 10-year Treasury Bond yield – has already tripled from a 2020 low of 0.5% to 1.5%. Though still low by historical standards, this sharp rise in yields in a short time will have caused immense losses somewhere in the hedge fund/speculative community. Higher US bond yields are already dragging up bond yields around the globe. The UK 10-year gilt yield has risen from an absurd 2020 low of less than 0.10% to nearly 0.8%. With global debt levels markedly higher than in the 2008/9 Global Financial Crisis (GFC) even relatively modest increases in bond yields pose a threat to global recovery.
The key question then is how high can US bond yields go? Most economists accept that there will be price increases to reflect the tightening of global supply chains, damage to productive capacity due to prolonged lockdowns and expansionary economic policies. However, they generally forecast only a modest and temporary bounce in inflation, and thus interest rates. There is an assumption that because the Quantitative Easing (QE) that followed the GFC did not result in higher inflation it won’t this time either. I believe this greatly underestimates the extraordinarily aggressive nature of the US fiscal and monetary response to the Covid-19 pandemic.
Today’s economists – including central bankers – largely ignore the relationship between broad money growth and inflation but it remains a powerful one. Sustained low broad money growth continues to mean low inflation and sustained rapid money growth still produces high inflation. This modern neglect of monetary analysis probably explains why economists remain largely complacent about current inflation prospects. They are not paying attention to the crucial difference between post-GFC outcomes and now. The GFC-induced QE programmes did NOT flow through to higher money growth. On the contrary, US M3 money growth only averaged around 3% p.a in the period 2010-19, and annual growth never exceeded 5%. A similar pattern occurred in the UK. This was primarily because, post-GFC, commercial banks were focused on restoring financial health by shrinking balance sheets and building up capital reserves. Central bank asset purchases boosted financial sector liquidity but this did not flow through to increased loans to businesses and households.
In contrast the impact of QE on money supply growth this time has been dramatic. Firstly, the size of the QE programmes has been much bigger, especially in the US. Secondly, while the EU banking system remains chronically impaired and unreformed, this is not the case in the US and UK. US and UK commercial banks have been far more willing and able to extend loans to the private sector than before. Thirdly, fiscal deficits have been much bigger and have in effect been monetised by direct central bank purchases of bonds. Direct funding of government spending by central banks has always been recognised as dangerously inflationary, often characteristic of banana republics. The net result has been an explosion of US broad money growth, with US M3 rising by 22% in the twelve months to January.UK broad money growth has been notably less rapid but a still high 14% over the same period*.
The US economy is heading for a boom/bust recovery
Although US money growth was receding towards end-2020 it is certain to remain at high levels as the huge fiscal stimulus proposed by President Biden is also heavily monetised. This massive new stimulus needs to be put in context. Due to the impact of the very sharp recession caused by lockdown, plus accompanying fiscal reflation, the 2019/20 US federal deficit ended up at $3.1 trillion or 17.9% of GDP. As the economy then recovered the deficit was originally planned to fall to around 7% of GDP in 20/21. In December President Trump signed off on a $0.9 trillion package of new measures, taking the forecast deficit to around 12% of GDP. The new Biden fiscal bill currently in passage through Congress adds a staggering $1.9 trillion of additional stimulus taking the likely deficit to 20% of GDP. To give further perspective the proposed spending for 21/22 is higher than the cost of all the wars fought by America – including the Civil War – since its founding. This in an economy already rapidly recovering from the massive Q2 2020 downturn -Q1 21 annualised growth is tracking at 10% – and set to be further boosted by a successful vaccination programme. The Biden package (also true of the Trump bill in December) consists almost entirely of increased welfare payments and state and local government grants, with virtually nothing that raises public sector infrastructure spending or incentivises private sector investment.
This mind-boggling boost to aggregate demand is being injected into a supply constrained economy. I therefore confidently forecast US inflation will move to and beyond the 5% level for a sustained period. The Federal Reserve may try to dampen down the resultant rise in bond yields but a 10-year rate of around 4% may be inevitable. Even Larry Summers – arch-Keynesian and ex- Treasury Secretary under President Clinton – warns of “inflationary pressures of a kind we have not seen for a generation”. The US economy and markets are set for a major “boom bust” scenario. Can a post-Brexit UK avoid a similar fate?
The UK can avoid higher inflation derailing the Post-Covid Recovery
The UK seems far less likely to have its post-Covid recovery derailed by a surge of inflation. UK broad money (M4) growth of 14% is significantly lower. Bank of England (BoE) Governor Andrew Bailey’s resistance to the introduction of negative interest rates is an encouraging sign the Bank will not go soft on inflation. Unlike the Fed the BoE has not formally committed itself to allowing inflation to overshoot its 2% target rate in the coming upswing. The BoE’s current asset purchase scheme runs until September, but as the economy picks up strongly from Q2 onwards, as now seems likely, the Bank should terminate the programme early. Contrary to current market expectations the Bank may well be looking to increase Bank Rate before year-end.
In stark contrast to the US, the UK has already announced deficit reduction measures. Cuts to current government spending were announced in the November Spending Review, as well as increased scope for Council Tax rises. In his Budget the Chancellor gave notice that various tax thresholds – notably personal income – will be frozen for five years as from next year. The UK Company tax rate is to be markedly increased from the current 19% to 25%, though only in 2023. These measures demonstrate a capacity to take unpopular decisions that is crucial to maintaining financial credibility, but will not hinder the initial upswing. The UK fiscal deficit for 20/21 is expected to be 17% of GDP, similar to the US, but then falls to around 10% in 21/22 and 4.5 % in 22/23. These deficits are still high but proportionate to the circumstances – particularly as a large portion of the deficits from now on will fund increases in public sector investment. The Budget also contained major tax incentives for private sector investment. All told the UK’s fiscal and monetary settings are far less worrying than in the US.
The UK’s escape from the regulatory and protectionist shackles of the EU makes it uniquely placed to reinforce its Post-Covid recovery with major supply side reforms and improved global trade links. Government initiatives are underway to reform UK regulations, the public service, the health service, and planning laws as well as to promote the R&D and science sectors. New laws have been passed by Parliament to ensure our agricultural, fishing and immigration policies meet UK needs. The introduction of UK free trade zones has taken a big step forward with chosen locations announced in the Budget. . The Trade Secretary, Liz Truss, has been successfully driving the UK’s post-Brexit free trade. Over 60 EU-derived trade agreements have been rolled over, with some significantly augmented and/or pledged for further liberalisation. Major groundwork for entirely new FTA’s with the USA, Australia, and NZ has been laid, a formal application to join the Asian trading bloc CPTPP lodged, and exploratory talks with Gulf states and the Latin American trade bloc Mercosur begun. A pact to explore a trade deal with India has also been reached – if successful the UK would be the first western country to do so.
Together with the large uplift in infrastructure investment underway all this suggests the potential to raise the UK’s productivity growth, as well as strengthening the currency, thus further reducing the inflation threat to recovery. I expect a relatively modest and temporary rise in inflation to around 3-4%, and remain confident in the view, stated in previous articles, that “The UK will be the fastest growing Western economy in the years 2021-25”.
The EU also faces a Bust, but without the Boom
The EU’s intractable structural problems have considerably worsened during the Covid crisis. Although Germany and its northern satellites were able to give significant protection to their economies during lockdown, this was not true of the weaker southern economies. The EU’s refusal to give more than a fig-leaf of assistance to Portugal, Italy, Greece, and Spain, has meant a marked rise in their already dangerously high debt ratios. Italy’s public sector debt is approaching 160% of GDP and rising strongly. The EU’s banking system becomes ever more impaired. In contrast to the UK there is no prospect of significant supply side reform or free trade initiatives. Reflecting its inherent protectionism, the EU has chosen to implement its trade deal with the UK in the most restrictive and obstructionist way possible. Intending to punish the UK for Brexit, it is instead incentivising the UK to reform its regulations and diversify its trade away from the EU as rapidly as possible, thus demonstrating once again the strategic sense of a rabbit with myxomatosis.
The EU will of course have some recovery as lockdowns are eased, but one enfeebled by chronic structural weakness and a shambolic vaccine roll out. A weak recovery will leave the EU extremely vulnerable to the rise in global bond yields generated by the US inflationary boom. Eurosceptic economists, myself included, have long predicted the ultimate demise of the Euro system, but still it staggers on. We should have recalled Adam Smith’s dictum that “there is a great deal of ruin in a nation”. However, an equally relevant dictum is that of Herb Stein, economic advisor to President Nixon: “If something cannot go on for ever, it will stop”. It may be that President Biden’s utterly reckless fiscal gamble inadvertently now sets the stage for the Euro’s final denouement.
Robert Lee March 4th 2021
*The monetary insights in this article have been heavily influenced by the work of the Institute of International Monetary Research (IIMR) headed by Professor Tim Congdon. Along with Charles Goodhart Prof. Congdon is the UK’s pre-eminent monetary economist. For those interested in delving further into the lost art of monetary analysis I highly recommend the IIMR’s website mv-pt.org.