Everybody knows that with all kinds of excess cash in the system, inflation is a significant risk if the economy picks up, and the Fed is too slow to take away the punch bowl.
But there’s another reason we might get inflation, as discussed in this weeks Morgan Stanley Global Monetary Analyst report: controlled inflation may be the only feasible solution to dealing with western debt-loads. Inflating away the debt is one of those strategies that everyone thinks, in the back of their heads, is bound to happen, but few actually call for as policy. And central bankers, in particular, aren’t keen to admit that it’s in their toolbox.
But obviously it is, and the question according to MS is whether central bankers should start intentionally inflating now, so that they don’t have to inflate like crazy a few years down the road when we’ve really maxed out the credit card.
With governmental coercion being unfeasible, is there a
possibility that independent central bankers might generate
inflation out of their own volition? If nothing else, they would
take a big gamble with their hard-won credibility. And history
teaches us that the reason behind most, if not all, episodes of
very high inflation has been monetary expansion to finance
government expenditure or reduce debt (see “Could
Hyperinflation Happen Again?” The Global Monetary Analyst,
January 28, 2099).
Still, there is a reason why a rational and forward-looking,
independent central bank may want to consider generating
(some) inflation. If the fiscal path is deemed unsustainable, it
may be preferable to create limited inflation early on – to nip
the debt problem in the bud – rather than to allow a mounting
debt burden and having to inflate a lot more in the future.
So, it may be best to bite the bullet and allow inflation now.
But how does one avoid throwing the credibility baby out with
the debt bathwater? Above all, if a central bank is to inflate, it
has to do so in a controlled fashion. Former IMF Chief
Economist Kenneth Rogoff’s proposal of a 6% inflation target
for a limited period of time could be a way of doing it. We think
that for Rogoff’s proposal to work, the central bank would
have to communicate explicitly to the public the level of
inflation targeted, the duration of the new policy, and the
timeframe for a return to a lower target – the exit strategy.
The question though is whether it actually works. Other analysis we’ve seen says inflating your way out of debt is more fantasy than reality.
An analysis from UBS’s Paul Donovan from back in August suggested that while it just doesn’t work: attempting to inflate your way out of debt leads to higher interest rates, and so all you do is sping your wheels (which makes sense).
As this chart supposedly demonstrates, periods of high inflation rarely coincide with a decrease in debt-to-GDP ratios.