One of the most heated debates in the financial markets is around inflation. Will the unprecedented actions of governments and central banks lead to higher prices? Why did they fail to generate it so far?

It is not possible to draw predictions if we do not fully understand what happened in the past. Let me then take the step back.

A brief background of how we got here.

In March, when most governments around the world decided to lock down the economies, everything stopped. Businesses shut down; employees stopped working; consumers stopped spending. We were heading into the economic abyss. Without support from governments, hardly any companies would survive this period. Unemployment numbers would skyrocket. Luckily, authorities didn’t wait too long to step up support which lasts until today.

To help you visualise the scale of government programs think about the UK economy. The government at the peak time was “employing” (directly and through furlough schemes) 55% of the total workforce in the country. Despite such massive fiscal support, we saw a mind-blowing drop in economic activity. Even today, the recovery path is very uncertain.

There are no free lunches in the economy.

Unfortunately, there are no free lunches in the economy. The governments’ actions had its costs. We ended up with much higher deficits and debt levels. What made things worse was a huge liquidity crisis we experienced back in March on top of ongoing economic and health situation. There was sell-off in almost every financial asset (even the safest US Treasuries at some point suffered heavy losses). The markets were on the brink of a sudden stop. If government actions were to have even tiny chance of succeeding, the markets had to be calmed down.

Central banks again as the buyers of last resort.

That was when central banks stepped in. The standard textbook reaction to lower interest rates was not enough. It does not address liquidity problems. Central banks had to reach out for their most powerful but often controversial tool — direct purchasing of assets (also known as quantitative easing). The amount of assets they already bought since March is large by any accounts.

We are thus in a precarious situation when governments are spending as if there were no constraints in their budgets, whereas central banks are partly making that possible by buying debt. It comes very close to what we call printing money. No wonder we are now worrying about a spike in inflation.

How does that compare with the Great Financial Crisis?

The main difference to what authorities are doing now versus what they did in 2007/2008 is how they spend money. During GFC, governments injected capital into large banks while central banks bought a large number of illiquid assets from them. Hence it was the banking sector that was a direct beneficiary of the support.

Back then, there were also lots of worries about inflation. Nothing like that happened though. The main reason was that banks didn’t spend extra money but put it aside as their reserves (in the central bank). It didn’t find its way to the economy, so it didn’t create extra demand (other than for financial assets).

This time is different.

The situation is different this time because we gave money directly to those who can spend it. Consequently, the supply of money (as measured by the so-called money aggregates M1 or M2) have risen. Yet, so far, that money is not being spent. It ends up as extra savings. So once again we have a situation when money is pumped into the economy, but it doesn’t fuel spending spree.

Cash is not flowing.

It is best described by what economists call the velocity of money. Every dollar that is flowing in the system can be spent many times to buy goods and services in the economy. What we are observing now is the sudden drop in the flow. In other words, there is much more money in the system, but it is not buying the same amount of products. Thus, so far, it has failed to generate expected price pressures.

The reason is simple. Investors are hoarding cash because there is still extreme uncertainty. Also, with low or negative interest rates, some people prefer to keep cash rather than invest.

This is a key to predict what is going to happen with inflation near term. As long as businesses and households do not have enough confidence to invest and spend we are not going to see materially higher inflation.

Pockets of price pressure in CPI baskets.

When we are talking about inflation, we should also mention the challenges with measuring it. The tremendous economic shock we just experienced has had many implications for our lives. One of them is that our spending behaviours changed as well. It will take time for statisticians to account for the impact properly. We had lots of reservations to the way the inflation was measured before the crisis, and now it will be even more difficult.

Another thing to keep in mind is the costs associated with the pandemic “new normal” world. Firms had to adjust to new regulations like social distancing and disinfection. Some companies had to adapt their supply chains. That brought immediately extra costs which pushed the prices of some products and services higher. Yet, we don’t know how permanent that change in prices is.

Structural long term forces impacting inflation.

So far, we touched on short term cyclical and supply-side driven factors directly associated with the pandemic. Yet, there are long term forces that are impacting inflation. I would group them into four categories.

Globalisation (or the end of it).

For the last few decades, the world economy was benefiting from globalisation. The capital and goods were flowing freely between countries. Companies could shift their production to countries with a cheaper workforce (like China or India). There was also a significant drop in transportation costs. As a result, the production costs were moving lower. That is probably going to change.

The rise in political tensions between the US and China will make a difference. Many Western companies will be more reluctant to shift their production. The pandemic also exposed the weaknesses of global supply chains. Many governments and companies realised the downside of being reliant on production only in one country in the other part of the world. All in all, I think globalisation will stop being a disinflationary factor.


Demographics is the trend that we discussed for many years. But for the majority of Western countries, the impact is only starting to be felt. We do not need to look far for examples of how that influence economy and society. Japan has been experiencing an ageing population for many years. As people get older, their propensity to spend is lower, and their savings are higher. That leads to lower demand for goods and oversupply of capital (also known as savings glut). It all has a strong disinflationary impact. Most countries are only starting to experience that.

Technological progress.

Technological progress is another example of a long term structural trend pushing prices lower. Why? Think of the impact Uber had on taxi fairs. Or what Airbnb did to the hotel prices. Or how the hardware equipment (computers, TVs, etc.) got cheaper over the years thanks to improved technologies. All those advancements made significant improvement in the quality of our lives. Many of luxurious goods in the past became accessible to the majority nowadays. I do not think nobody predicts technological progress to stop now. If anything, we only see an acceleration of it.

Capital vs labour.

There is another point which is related to technological advancement, less optimistic. The most prominent companies in the world today — usually closely associated with the tech sector — do not need that much workforce. They rely on technologies, and their products are easily scalable without many investments. Companies like Facebook or Google do not build huge factories. They do not hire thousands of workers. Even those production companies who rely on labour, now often expand the use of robots and automation.

In these conditions, it is challenging for workers to have strong bargaining power with companies owners. Why is this important when talking about inflation? Because in the world where capital rules over labour, it is easy for companies to keep wages and prices low. It will remain problematic for workers to ask for a more significant share of profits if capital and technology is so cheap.


All in all, out of the four long term structural forces, three of them have a clear disinflationary impact. Only one — globalisation — might likely to change soon but even that is very uncertain.

I do not exclude inflation moving materially higher in future. But it is difficult for me to imagine how we overcome the major driving forces. Again, the experience of Japan since the begging of the 1990s is very convincing. Whether new tools and new approach developed by fiscal and monetary authorities will change the situation time will tell.