The head of St. Louis FRB, James Bullard, attempted to put an end to the issue of “behind the curve” Fed, saying that unemployment could jump up to 30% in the second quarter. This jump would be caused as the onset of infection prompts the government to deepen restrictions which have a destructive impact on the economy. Bullard sounded even gloomier than the industry doomsayers, saying that GDP could shrink by a half compared to the second quarter of 2019.

The most important aspect of the current rhetoric of central bank officials is rising emphasis on the importance of fiscal stimulus. The discussion is steering from running out of ammo monetary policy to the need of better “coordination of fiscal and monetary policy”. Bullard called to compensate income losses of broke consumers with a substantial fiscal package of $2.5 trillion. One unintended and completely unexpected consequence of this incredible government boost could be a surge of inflation but, for some reason, this possible issue is now overlooked by many experts. Indeed, it is difficult to imagine that it will turn out to be a weak link in the whole scheme of “unlimited stimulus”, given the tepid response of price growth to intense monetary stimulus in the past decade.

The current situation however looks different. The monetary policy, due to the decreasing positive impact on inflation, gives way to fiscal stimulus which tends to be more inflationary. The wave of national lockdowns also leads to a rather rare (but long-lasting) supply shock. If the US government unlocks this fiscal spree it could lead to one interesting effect: disposable income will increase but production of goods and services lag (or even decline). In other words, disposable income will temporarily lose connection with demand for labor (and even supply due to lockdowns). As a result, this can lead to massive demand-pull inflation due to demand rising much faster than supply

 

The blue vertical line on the graph – supply curve, now characterizes the quarantine effect (insensitive to price inflation due to constraints)
There are also arguments against the surge in inflation, such as declining prices on resources. This then pressures PPI and, in turn CPI; and the fact that the fiscal stimulus will be used to pay for essential, non-discretionary goods where prices are less elastic to demand. It is highly likely that fiscal stimulus in combination with a fast oil market recovery could potentially be a very dangerous mix for the US.

But, why was there no inflation during the credit expansion after the 2008 crisis? In my opinion, the explanation lies in the following. Fiscal support usually entails a direct increase in disposable income. In contrast to the effect of low interest rate, which can increase the demand for borrowing (and then consumer spending) it does not necessarily lead to this (because of inelastic demand for loans to interest rate, low inflation expectations, bottlenecks in credit channel, etc.).

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