Inflation is still unlikely but if it comes, we'll be too slow to react

Published on Friday 29 May 2009 13:58

THE jury is still out on quantitative easing and whether it will lead to massive inflation. Pessimists are convinced it will spark a flight from money into real assets, whether there is a recovery or not.

Confidence in holding cash is likely to dissipate rapidly and, as the velocity of circulation rises, so too will inflation.

Some pundits argue that, as demand falls below supply, creating an "output gap", the prospect of inflation will diminish. Another parallel view is that the world output gap has been grossly exaggerated and that the credit crisis has been responsible for the demise of the banks and much of the corporate carnage throughout the developed world.

The result has been shrinking productive capacity, and with simultaneous and aggressive stimulation of demand, inflation becomes more likely. However, when this threat becomes a reality, governments will stop printing money and cut back on their fiscal stimuli – but all this will probably be too late. It will also be difficult for governments to revert to conservative financing, which would plunge economies back into recession.

In short, quantitative easing is an intoxicating drug, which central banks will continue to use for fear that any reduction may set back the recovery. Some degree of inflation has to follow and the inflation optimists' argument is much simpler.

Japan must be the best case-study for inflation optimists. For over ten years, the Japanese government increased money supply by more than 10 per cent. Then it injected 10 per cent of GDP in the banks' capital base – however, the banks continued to shrink. Finally, the Japanese central bank doubled money supply over a period of just two and a half years.

This would be like the UK boosting quantitative easing not by the initial 75bn, nor by 125bn and not even by 150bn, which will be government's next upside adjustment, but by a trillion and then by the same again. And what happened in Japan? Certainly not inflation.

But even on the premise that it's different this time, inflation still looks an unlikely outcome in both the short and medium term while the world economy contracts and recovery is at best sluggish. However, if I'm wrong and inflation does become a problem, you can bet that governments will act too slowly in aggressively cutting money supply. Nonetheless, it could still go either way.

&#149 Yuill Irvine is managing director of IFA Dunedin Independent