The inflationary process is in its early stages, and it will be particularly strong because it arises in part from a devaluation of the world’s reserve currency. Governments throughout the world printed and spent trillions in their pandemic related efforts, but none of their actions came close to the American response. American households literally received trillions in newly printed money that they are just beginning to spend. Inflation will become more obvious as that money moves through constrained supply chains and the global dollar system. Most foreign countries tether their currency to the dollar, effectively forcing them to at least partially import inflationary U.S. policies. In this post we follow the free money as it makes its way through the domestic and global economy, explain why reserve currency devaluation is particularly inflationary, and suggest prices have further to rise.
From Printer to People
The U.S. took full advantage of its reserve currency status and deployed a pandemic response that was exceptional in its scale and form. Trillions were spent, with notable cash infusions that include $1.6t in direct payments to individuals and $1.1t in forgivable in “loans” to small businesses. The total fiscal response amounted to 25% of GDP, while the average response among other advanced economies was only 12%. Note that weaker sovereigns do not have the ability to deploy this level of “helicopter money.” Emerging markets and low income developing countries only mounted a very modest fiscal response.
The fiscal response was completely financed by money creation, which devalues the currency. Recall that QE changes the form of dollars, but it is deficit spending that actually creates dollars. From the perspective of non-banks, QE merely swaps Treasuries for bank deposits. But the issuance of a Treasury security creates out of thin air what are essentially dollar bills that pay interest. In practice, Treasury debt will never be repaid and just rolled over perpetually. When Treasury and Fed act in concert, then fiscal spending results in the issuance of new bank deposits out of thin air.
In a prior post we reviewed the distribution of the new money by bank account size, but we can also splice the distribution by entity type. Here we see a $2t surge of checkable deposits held by U.S. households (as opposed to businesses or government entities etc.) This is an enormous increase in purchasing power, and it looks like there is a lot left.
From Households to Businesses
American households are living up to their reputation as big consumers and spending the money they received. Real consumer spending is above pre-pandemic levels, largely driven by a significant increase in spending on goods. This is likely in part because pandemic restrictions limited access to services. If restrictions are one day fully lifted then spending on services should also easily surpass pre-pandemic levels. The increased consumer spending can also be seen in surging corporate profits, which mirror the increase in household cash holdings.
From Households to Global
Increased U.S. demand flows through interconnected supply chains, so higher U.S. consumer spending also impacts economic conditions abroad. This can be seen in a widening U.S. trade deficit, which is at historic lows. From a foreign country perspective, increased export demand results in inflationary pressures which can be moderated by allowing their home currency to appreciate. But that policy tool is limited when the increased demand arises from more dollars.
The world runs on a dollar standard much like it once ran on a gold standard. Most of the trade in the world is invoiced in dollars, and most FX trades are against the USD. The dollar exchange rate impacts a foreign country’s trade competitiveness, and the solvency of its corporations. This means many foreign countries manage their currency by softly pegging it to the dollar as if it were gold. The impact of an influx of dollars under a dollar standard is like the discovery of a new gold mine under the gold standard: globally inflationary. This is part of the reason why some emerging markets have already started hiking rates.
The inflationary impact of a currency devaluation arises from real transactions but also from expectations. When the Roosevelt Administration devalued the dollar it was very open with its intent to inflate prices. The public responded accordingly and rushed out to make purchases today in fear of higher prices tomorrow. This time around the policies are also obviously inflationary, but the accompanying messaging downplays inflation. Note that official sector communication is a policy tool used to influence expectations, and not necessarily a statement of belief.
Soothing words from officials and their friends can help tamp down on inflation, but only temporarily. The current context is tremendously inflationary. Households gained trillions in cash, their assets values are all time highs, and they feel confident enough to quit their jobs at record rates. They are very likely to keep spending (lots of) money. Supply chain constraints are also real, as are rising energy costs. Should the public begin to realize that it makes sense to buy today rather than tomorrow, then inflation could really skyrocket.