EC Will A Demand-Side Shockwave Keep Inflation Muted?

It’s no small thing when a massive, supply side shock wreaks havoc across the global economy. Economic theory predicts a sharp rise in prices from such events. All else equal, if supply drops, prices are expected to rise. But all else has been far from equal in the coronavirus crisis of 2020.

As a first step in quantifying the demand shock that’s been unfolding in the economy, consider the change in the US personal savings rate. Since 1960, savings as a percentage of disposable personal income has ranged from roughly 3% to 15%, holding within a 5%-to-10% range since 2010. But that was before the coronavirus. In April, the savings rate skyrocketed to 32%. The rate pulled back in May to 23%, but that’s still far above the historical range.

What are the economic implications for a sudden surge in saving? One possibility: the change reflects pent-up demand that, once unleashed, will generate strong upside pressure on prices, which in turn will fuel higher inflation. That’s a relatively positive scenario in terms of the economic outlook because it suggests that the recession will soon fade as consumers begin spending again.

But that’s a textbook analysis that faces a number of real-world complications, starting with the obvious one: coronavirus. America continues to struggle with managing Covid-19 and so the prospects remain unclear for the timing of a return to something approximating normality.

One of the critical pieces of blowback is the high rate of newly unemployed workers. Initial jobless claims have been rising by an usually high one-million-plus every week for months. The trend suggests that the forces of demand destruction in the consumer sector aren’t about to fade in the foreseeable future.

It’s also important to recognize that even before the coronavirus crisis there was a long-running disinflationary bias coursing through the US economy. Consider the history of the velocity of the money supply (a measure of the rate that money is exchanged), based on M2 money stock. A downside trend has been in force for most of the past two decades and there’s a good case for assuming that the coronavirus shock has only strengthened the slide.

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Moon Kil Woong 1 week ago Contributor's comment

The economy would be healthier if wealth was distributed more evenly and if the middle class was larger. That said, inflation is not a concern yet because of falling demand and lower consumption. Most excess money is going into further asset inflation which tends to create bigger wealth disparities.

Deflation will accelerate when stimulus ceases.

William K. 1 week ago Member's comment

Definitely an interesting post. And an explanation of why inflation has not already taken off. And the explanation makes sense if I understand it, I suppose. But the reasonably rational logic states that creating lots more available money will bid up prices is based on a lot of examples where it did just exactly that. So it is a reasonable expectation, even if it is wrong. So now the question becomes who is correct?

But the part about "the velocity of money" brought out a term that I was not familiar with at all. Oh Well.