Abstract: Recent surge in bulk commodity prices and US treasury yields, as well as Biden’s $1.9 trillion stimulus plan and continued monetary easing in the US have raised concerns for global inflation. The author analyzes whether such concerns are warranted by looking at the drivers behind economic recovery and the source of money supply. He points out that the above-mentioned phenomenon reflects market expectation for globally synchronized recovery driven by the rebound in demand and its multiplier effect across countries. In terms of monetary and fiscal factors, liquidity expansion last year is mainly endogenous in China and exogenous in the US, bringing debt and financial risks to the former and inflation risks to the latter. Nevertheless, the US is unlikely to see continuous high inflation. Looking ahead, China’s monetary policy is expected to tighten before easing again in 2021 in order to relieve debt pressure and mitigate financial risks, while the Federal Reserve may tighten monetary policy gradually, possibly by raising long-end interest rates. The author also notes that countries are increasingly moving to enhance financial regulation to stem credit growth and boost money growth in support of fiscal expansion, which will lead to inflation.
Since February, crude oil and other commodity prices have risen sharply, while Treasury yields also rose rapidly. Although the market was prepared for a global recovery this year, the rapid rise of commodity prices and Treasury yields has been beyond expectation. Meanwhile, the Biden administration is pressing ahead with the $1.9 trillion stimulus package, and the Federal Reserve has reiterated that it would not exit monetary easing any time soon.
Against this backdrop, market concerns over inflation worldwide increased significantly. How should we understand the current situation? Will we see inflation higher than before in 2021? Will the Federal Reserve tighten monetary policy as a result? What are the implications for the macroeconomic policy framework in the medium to long term?
I. Unconventional global recovery
To answer these questions, we first need to understand the nature of recent economic fluctuations: Where are we in the economic cycle? What are the drivers behind the fluctuations?
Traditional economic cycle, generally demand-driven, has an endogenous mechanism. From recession to recovery, demand often rebounds first stimulated by policy, which then boosts production. During this process, demand recovers faster than supply, output gap falls, and deflationary pressure eases or inflationary pressure rises, eventually monetary policy will tighten.
But this time was different as the shock was exogenous and mainly supply-driven. The main impacts of the pandemic were disruption of production and social isolation, though demand was also affected. As the virus was put under control and social quarantine was lifted, supply began to recover and demand rebound, and the economy began to return to normal.
In reality, the mechanism of the COVID-19 shock was more in line with the real business-cycle theory. The real business-cycle theory downplays the role of money demand in economic fluctuations, and believes that economic fluctuations are mainly driven by factors on the supply side, such as technological progress and natural disasters. In 2020, massive monetary and fiscal support by global policymakers did not prevent the sharp decline in economic activities, which were constrained by physical constraints due to the public health crisis. As the pandemic situation improves in 2021 and physical constraints are eased or even lifted, global economic activities will certainly rebound independent of fiscal and monetary factors. This is key to understanding the current business cycle.
Another different characteristic of the impact of the COVID-19 is its high synchronicity across countries. In the past, there was usually one source that caused cyclical fluctuations. For example, the Asian financial crisis mainly originated in Asia. Although the US subprime mortgage crisis was known as a global financial crisis and dragged down the global economy, still it was the US which was impacted the most. Thus, traditional demand-driven economic fluctuations were not synchronized globally.
However, during the COVID-19 crisis in 2020, all countries in the world were impacted by the virus, with global economy in a synchronized downturn, followed by synchronized global monetary and fiscal easing. Although the intensity of the policy easing was different among countries, policy orientations were the same. In 2021, such synchronicity will be reflected in the synchronized upward movement of the global economy.
To sum up, the basic feature of the global economy in 2021 will be recovery, and synchronized recovery means that the multiplier effect of demand among countries and regions will increase (for instance, through global trade), and its support for economic growth will be stronger than before. The recent rise in commodity prices and the continued upward trend in the US Treasury yields partly reflect market expectations of a synchronized recovery of the global economy.
II. Exogenous money growth brings inflation risk, while endogenous money growth causes debt risk to rise
Aside from real economy factors, fiscal and monetary forces also deserve attention. What role will the liquidity injected in 2020 play in 2021? How to assess the monetary condition this year? Will we see higher-than-before inflation as a result?
One way to understand the role of money is to look at its source, that is, to distinguish between endogenous and exogenous supply of money. In short, exogenous money supply is independent of economic operation itself and not generated as a result of financial cycle. One example is gold, the output of which is independent of human activity. Gold is considered exogenous money supply under the gold standard. Exogenous money can also be injected through fiscal policy, which reflects the policy orientation of the government rather than spontaneous activities of the private sector. A typical example of endogenous money is credit which reflects the internal dynamics of the economy, such as economic growth, demand for credit in the real estate sector etc.
It is important to distinguish between exogenous and endogenous money supply when analyzing monetary expansion during the pandemic. Historical experience tells us that the main problem brought by the excessive expansion of exogenous money is inflation, that is, prices rise as excess money is created, because exogenous money supply exceeds the demand for money in the economy. In contrast, the main problems associated with excess endogenous money supply are asset price bubbles and financial crises, typical examples of which include the crash of the US stock market in 1929 and the US subprime mortgage crisis in 2008. Endogenous money is associated with debt problems and asset prices.
In 2020, China provided liquidity primarily through credit expansion, which is basically an endogenous money supply. Although liquidity expansion happened at a faster pace in the US, a large part of which was exogenous money from fiscal investment. Calculations show that the US M2 growth rate reached 25% in the second half of 2020, of which nearly ten percentage points came from fiscal investment. During the 2008 financial crisis, US fiscal stimulus also contributed significantly to liquidity provision. But the fiscal expansion at that time was mainly to rescue financial institutions, and did not directly benefit real economy entities such as enterprises and households. In contrast, this round of fiscal expansion in the US directly went to individuals and companies, typical exogenous money supply.
For the capital market, one of the risks it faces this year is higher-than-expected inflation in the US. In the past two months, both the implied inflation expectations reflected in the US bond market and the inflation expectations based on consumer surveys have seen a significant increase. Although the actual inflation data has not yet been revealed, with the advancement of vaccination and the implementation of the fiscal stimulus plan, consumer demand will rise, so will inflation. In addition, in the special context of the pandemic, we also need to consider inflationary pressures brought about by supply contraction, such as global supply chain disruption, logistics breakdown and insufficient labor supply caused by social distancing. The recent decline in the supply of crude oil, agricultural products and semiconductors due to extreme weather is also worthy of attention.
A persistent hyperinflation in the US is not very likely, because some of the deep-seated problems that led to the current low inflation show no signs of changing. For example, excess savings and insufficient consumer demand caused by the polarization of wealth will curb inflation. Although fiscal expansion has increased the disposable income of the middle and low-income groups, it cannot fundamentally solve the problem of polarization between the rich and the poor. However, from the perspective of counter-cyclical adjustment, how to manage the rising inflation expectations remains an important challenge. A too early or late monetary response can lead to mistakes. Judging from the Fed's statement, it is more likely that US monetary policy will react late, which will increase the volatility of the financial market.
Unlike the situation in the US, the major problem faced by endogenous money supply is the debt issue. Calculations show that after the substantial expansion of credit in 2020, the debt to GDP ratio (macro leverage ratio) of China's private sector has increased by about 18 percentage points, the largest annual increase since the global financial crisis. The Central Economic Work Conference at the end of 2020 emphasized that macroeconomic policies must be consistent, stable and sustainable. The first two words mean there should not be any sharp turn in policy, while sustainability calls for attention to medium-term risks and a balance must be struck between economic growth and addressing debt risks. Therefore, it can be predicted that the rate of monetary and credit expansion in 2021 will be slower than that of last year. One implication of this is that the ratio of the debt service burden to credit growth of the private sector will bottom out. Historical experience shows that rising debt service burden will increase the pressure of debt default and reduce investors' risk appetite.
What is the implication of the above judgment on macroeconomic policies?
The US may have an expansionary fiscal policy and a tight monetary policy. The Biden administration intends to launch a $1.9 trillion stimulus package in addition to the $900 billion plan released right before Trump stepped down, the total of the two will add up to $2.8 trillion, close to last year's $3 trillion package. Implementation of the stimulus will further aggravate upward pressure on inflation. This means the US has to tighten its monetary conditions at the margin, which can be realized by an increase in the long-term interest rates rather than the Fed raising interest rates (because the Fed has adopted average inflation targeting, its tolerance for inflation has increased).
In the medium term, fiscal stimulus will help the US economy achieve full employment ahead of schedule. In the end, the Fed will tighten money supply and the short-term interest rate will rise. Recently, overseas capital markets begun to discuss when the Fed will start raising interest rates, which can be seen as a response to the potential impact of the large-scale fiscal stimulus.
Because China has only limited room for fiscal expansion, the balance of its macroeconomic policies is mainly reflected in the interaction between monetary policy and supervision. The rise in China's short-term interest rates since January may be related to the rapid credit expansion and the pressure of rising asset prices. As a result, monetary conditions must be tightened first. If the real estate market cools down, the endogenous credit expansion momentum slows, or the debt default pressure increases, monetary policy will face the pressure of providing more liquidity, and there will be more room for a loose monetary policy.
This means that China may first tighten monetary policy and loosen it later this year. The logic behind is the debt problem mentioned above. Looking ahead, under the trend of deleveraging, the "seesaw" relationship between money supply and credit will be an important dimension when studying China's monetary policy for a long time to come.
III. There will be tight credit, easy money and fiscal expansion
The COVID-19 pandemic has brought drastic short-term shock to the economy and reshaped its structure. US Treasury Secretary Janet Yellen pointed out in her inauguration letter that the post-pandemic economy will experience a K-shaped recovery, with different sectors and groups showing different paths of revival. For example, contactless sectors like finance and the internet industry will pick up faster, while contact-intensive sectors like recreation, catering and tourism will take time to recover. As the income in contactless sectors is on average higher than in contact-intensive sectors, the pandemic will deal a bigger blow to middle and low-income groups than to high-income groups, thus widening the wealth gap.
An implication of this is that future macroeconomic policy should not focus growth and efficiency only, but should address structural upgrade and equity. This is partly manifested in the increasing role of fiscal policies around the world. This trend is already obvious in the US as the Biden administration pushes ahead with the $1.9 trillion stimulus plan. Yellen further indicated that the best thing to do at the moment is to “act big”. The market expects further moves by the administration in infrastructure investments, environmental protection and tax reforms.
Biden’s stimulus plan is ‘inclusive’ as it intends to allocate more of the fiscal funds to individuals via relief in cash and small businesses via loans. The administration also plans to elevate the minimum wage from 7.5 to 15 dollars/hour to step up support for lower-income groups.
Meanwhile, policymakers’ understanding of government debt sustainability is also changing. According to international practice, the public debt to GDP ratio is an important criterion in assessing government debt sustainability. The Maastricht Treaty signed by the European Community in 1992 proposed the threshold that a government’s debt should not exceed 60% of the GDP; the IMF also used to suggest a sustainable level of government debt as not higher than 60% of the GDP for developed economies and 40% for developing economies.
However, Yellen recently argued that a better indicator would be interest expenditure on government debts as a share of GDP. The logic is that although the US government has a huge amount of debt in absolute terms, it does not incur very high interest costs given a low-rate environment. As long as the nominal GDP growth rate is higher than the interest rate, there is no need to worry about government debt sustainability.
Of course, Yellen’s argument is based on the special situation in the US now and the status of the US dollar as the global reserve currency. However, there is no deny that given a low-growth global economy with low interest rates and a widening wealth gap, the marginal costs of government financing have been much lower than before, while the potential marginal benefits of fiscal policies (e.g. boosting aggregate demand and narrowing the wealth gap) have risen. If we do a cost-benefit analysis, it’s clear that fiscal policy will be more attractive, and dominance of fiscal policy could be a noteworthy trend in the mid-to-long run.
Amid financial liberalization over the past four decades, the world at large has witnessed massive credit expansion, and financial cycles have become a major force driving economic fluctuations; financial risks as a result of money growth (debt accumulation in the private sector) and asset price bubbles have worsened income inequality. In this process, fiscal policy focused more on its own balance rather than being functional in serving the balance of the entire economy. During the decade after the subprime crisis in the US, financial regulation was strengthened, and the private sector deleveraged; although fiscal policy played a part in sustaining financial institutions, its direction did not change, and monetary easing was the primary means to support the real economy. Tight credit and easy money were the main features of macro policy and interest rates slashed.
The pandemic seemed an important turning point that changed the fiscal policy thinking and methodology of developed economies. These countries turned to attach less importance to fiscal balance and worry less about government debt sustainability. Fiscal policy is reoriented toward supporting the overall economic balance and structural adjustments. Macro policies will further move along the path of “tight credit, loose monetary policy and expansive fiscal policy”; in other words, financial regulation will stem credit growth, and money growth will support fiscal expansion. Compared with credit expansion which bring asset price hikes and income inequality, this path will lead to inflation, with an important side effect being adjustment of asset valuation that was pushed up too high previously.
Following the National Financial Work Conference in 2017, China stepped up financial regulation. Credit tightened as a result but expanded again in 2020 following the pandemic. As the economy recovers, deleveraging and financial risk disposal could again become the focus of concern. Because China and the US are at different stages of the financial cycle, the US has had almost ten more years of tight credits than China, but in the coming years, tight credit, loose monetary policy and expansive fiscal policy could also be the major trend for China. Behind China’s success in poverty alleviation are society-wide efforts led by proper public policy and underpinned by fiscal support. To realize common prosperity and high-quality economic growth, fiscal policy, direct or indirect, will need to play a bigger role.
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