COVID-19 Pandemic Could Lead to a Rising Risk of Inflation

By Frederic Bouchet, Ph.D.
Faculty Member, School of Business, American Military University

Governments all over the world have massively intervened to sustain their domestic economies that were brought to a halt by COVID-19. In the U.S., Congress has passed several large stimulus packages to support both businesses and households. But it seems likely that more federal aid will be needed because it will take time for the economy to fire on all cylinders again.

Since the federal government was already running a massive deficit, all the money poured into the faltering economy had to be borrowed. But it would have been difficult to find such a massive amount of funds on the financial markets.

So the increased demand for dollars was met by an increase in supply from the Federal Reserve (“the Fed”), which purchased government securities and thus provided the U.S. government with the cash needed for the stimulus packages. This is the way money is printed in our modern economies.

Massive Borrowing by Governments

Of course, the U.S. is not the only nation to borrow massive amounts of money. Most rich countries have had no choice but to do the same to prevent the collapse of their economies.

This leads to another issue connected to the role of the dollar as the international currency. International loans and bank transactions are mostly done in U.S. dollars; this includes the huge oil trade, for instance. When economies started slowing down because of the pandemic, central banks all over the world rushed to get dollars to ensure they would be able to fulfill their current and future obligations.

To avoid an international crisis, the Fed has opened swap lines. A currency swap line is simply an agreement between two central banks to exchange currencies. In this case, these lines have been opened to allow central banks all over the world to borrow dollars in exchange of their own currencies. According to the Fed, these U.S. dollar liquidity arrangements will be in place for at least six months and allow foreign central banks to borrow up to $450 billion.

Of course, there is no guarantee that the foreign central banks will be able to repay the dollars within that time frame. If repayment is impossible, the swap then becomes a loan between central banks.What this means is that the Fed has been providing – and is likely to continue providing – huge amounts of dollars to both the U.S. government and the rest of the world.

In a recent MarketWatch interview, Fed Chairman Jerome Powell declared that there was no limit to the amount of money the Fed was able to lend. “The Federal Reserve’s balance sheet expanded to a record $5.3 trillion in the week ended March 25 from $4.7 trillion in the prior week,” MarketWatch reported, citing the central bank. This is money creation at its best. Clearly, the quantity of dollars that will be circulating all over the world looks to be quite high.

A Simple Story of Supply and Demand Ups and Downs

On any market, when the supply of a product increases while demand stays the same, its price decreases until the market comes into equilibrium. This also applies to a monetary unit like the dollar: Its price is determined by the demand for the currency and its supply. An increase in the amount of dollars available (supply) will push its price lower.

If the value of a dollar decreases, that means it will take more dollars to purchase things. What used to cost five dollars may now cost six. That’s inflation.

Another way to make this point is to see that, when there is too much money chasing too few goods, the result is inflation. This will not happen immediately, since the demand for products is currently low because so many of us are stuck at home and millions of Americans have lost their jobs.

Things will change as economic activity picks up, whenever that is. Demand for products is likely to increase as people return to work. Inflation might then become a reality.

Wealthy Nations Have Been Borrowing Massive Amounts to Finance Their Stimulus Packages

There is another factor that could play a role in bringing back inflation. As mentioned, wealthy governments have been borrowing massive amounts of money to finance their stimulus packages. At the same time, their revenues have literally been collapsing. Firms have shut down, reducing corporate taxes; unemployment is reaching record high levels, resulting in less income tax revenue; and consumer purchasing has been reduced to a minimum cutting sales taxes.

More expenses, less revenues: government debt is rising fast, which will have consequences for future government budgets. Last year, the interest the U.S. government paid on its debt was around $363 billion, which represented 8 percent of the federal budget.

Nobody knows how much this debt payment will be next year, as it seems likely that more spending will be necessary to support the economy. All we know is that the debt will be much higher, and so will the yearly interest paid on that debt. This will put more and more pressure on government budgets.

It may then become tempting for policy makers to raise the inflation target that has been driving monetary policy. For some time now the Fed has been aiming at a 2 percent yearly inflation rate. Adjusting this target upward would reduce the nominal value of the debt.

Quite simply, high inflation devalues future payments and helps borrowers while lenders become worse off. Lenders suffer even more when inflation is unexpected, meaning that it was not taken into account when the interest rates for the loans were agreed upon.

Annual inflation in the U.S. has been low for a long time, as can be seen in the Bureau of Labor Statistics table below which shows the average inflation rates from 2000 to 2019.

We have all become accustomed to these sorts of numbers, but the reality used to be quite different. To provide a comparison, look at the inflation rates between 1970 and 1990:

Nobody would recommend a return of the high inflation rates seen during the second part of the 1970s. However, it is noteworthy that the U.S. economy grew steadily in the 1980s despite an inflation rate that was significantly higher than any seen since 2000. Therefore, policymakers may be tempted to let prices rise faster, which would lower the value of the government debt over time.

Of course, the future presents many unknowns as world governments figure out the best way to reopen their economies. There are predictions that we will need to find a way to live with the coronavirus until sometime next year when reliable vaccines could be available.

However, one thing is certain: Governments have little choice but to keep on propping up their economies, thus requiring an injection of U.S. dollars to levels never seen previously. Then, due to the law of supply and demand, inflationary pressures are likely to appear, which will make government debt more bearable. This situation may very well become our new normal.

As a homeowner with a fixed-rate mortgage, I wouldn’t mind that scenario at all! My lender, however, would not be so thrilled.

About the Author

Dr. Frederic Bouchet is an associate professor in the School of Business at American Military University. He holds an M.S. in math and economics from the Paris Institute of Technology for Life, Food and Environmental Sciences (AgroParisTech) as well as an M.S. and a Ph.D. in agricultural and applied economics from Virginia Polytechnic Institute and State University.

Dr. Bouchet was an economic and financial advisor for several private and nonprofit firms, primarily in the food industry sector, during the 18 years he lived in France. While there, he also served as the Chief Operating Officer for a network of European nonprofit organizations. Dr. Bouchet has taught mathematics and economics in the U.S. for the last 15 years.