Inflation has come down sharply since the pandemic hit in the first months of this year.

The inflation rate is currently just over 1 per cent in the US, close to zero in Canada and the UK, and is actually negative in the euro-zone and Japan.

Of course, economic slumps usually cause inflation to fall, so this is no surprise.

One reason for this is that the price of commodities falls as economic activity slows. For example, the price of Brent crude has fallen from $70 to $40 per barrel since the beginning of the year, which has caused the price of gasoline in the US to fall by nearly 20 per cent.

Prices of hotel accommodation and airfares have also plummeted, for obvious reasons.

Not all prices have fallen

Granted, not all prices have fallen. It is generally more expensive to get a haircut now than it was a year ago. And with more people working at home, the price of furniture and garden plants has shot up.

The prices of second-hand cars have risen in many countries as people try to avoid public transport. But, in general, so long as the economy remains weak – which is likely to be for a long time yet – inflation will stay low.

Looking beyond the pandemic, though, there are reasons to think inflation may rise.

For a start, the activities of central banks are directly boosting the money supply, as money is being created electronically in order to buy government bonds.

This money allows the government to transfer funds to households, for example, through the furlough schemes which were adopted during the lockdowns.

Risk of hyperinflation

An increase in the amount of money in circulation usually causes prices to rise. In extreme cases it can lead to hyperinflation. For example, the inflation rate in Germany was once over 100 billion per cent!

Admittedly, the links between money growth and inflation are not automatic. Firms and households will want to hold higher savings just in case for some time because of uncertainty about the pandemic.

And even if households do spend the money, companies should be able to increase their output soon to meet this demand, rather than raising prices.

But once output gets back to normal, the extra demand could fuel inflation. Much will then depend on how central banks respond when and if they see that inflation is picking up.

To nip in the bud any increase, they could raise interest rates or reverse the rise in the money supply through a process of ‘quantitative tightening’, that is, selling some of the bonds they’ve bought.

But there is no guarantee that they would do that. Central banks may want to contain inflation but make an error.

It could be accidental

The last period of high inflation in major developed economies, during the late 1960s and 1970s, was accidental, rather than a deliberate strategy. Inflation reached over 10 per cent in most advanced economies in the late 1970s, and as much as 25 per cent in the UK.

Alternatively – and this is perhaps a bigger concern – governments might try to engineer more inflation.

Inflation would make it easier for governments to pay off their debts, because it would increase the nominal amount of taxes they receive, while the value of the debt outstanding wouldn’t change.

To achieve high inflation, governments may put pressure on central banks to keep interest rates low, either by appointing more compliant central bankers or by changing the central banks’ mandates.

It’s true that monetary policy was passed on to independent, inflation-targeting central banks in the 1990s precisely to prevent governments from allowing inflation to rise. New Zealand was the first country to make this change, in 1990.

But the current inflation-targeting regimes are not set in stone.

The Fed changed tack

The US Federal Reserve has recently made a subtle change to its goals and now tries to control the average inflation rate over several years; this means that its policymakers should tolerate an overshoot of the 2 per cent target.

Some fear that this could prove to be the thin end of the wedge.

Inflation risks are particularly high in countries where central banks are vulnerable to political pressure, and where government debt burdens look hard to sustain. This is often the case in emerging markets.

Among advanced economies, inflation risks are probably highest in the US and perhaps the UK, where governments might be more tempted to run bigger fiscal deficits after the crisis.

Risks are lower in Japan and the euro-zone because these economies have had very low inflation for many years.

Inflation can get stuck

When people expect inflation to stay very low, it can get stuck at a low level. So, it’s possible that later this decade there could be a period of divergence in inflation rates in the major developed economies not seen since the early 1980s and early 1990s.

For now, I still think it’s more likely that the inflation rate will remain low in most countries, even after the pandemic has passed.

But it would be foolish to ignore the possibility that this decade sees inflation become a serious problem for the first time since the 1980s.

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