One of the most important questions in financial markets today is inflation. Over the past few months, investors have begun to worry that ultra-loose monetary and fiscal policies will trigger a sharp and persistent rise in prices across the board around the world once the worst of the pandemic is over. It is really crucial to know whether these fears are valid or not because rapid price increases could trigger all kinds of problems. For a start, just the fear of central banks raising interest rates could cause sharp corrections in financial markets. Yet, it is difficult to be sure that we will indeed see inflation raging in our midst. After all, economists are squabbling over what really causes inflation and cannot agree on how much inflation risk there is.
Our take is this. First, it is wrong to fixate on inflation alone. Imbalances appear not just in the form of rising prices but also as swelling external deficits or dangerous bubbles in financial or real estate markets. Second, even if policymakers have made serious misjudgements, there could still be countervailing forces that reduce the risk that these imbalances will really emerge. Our bottom line is that investors may be worrying about the wrong thing — we are not likely to return to the bad old days of high inflation that people of my generation suffered in the 1970s. At worst, we will see episodes of inflation that eventually peter out. But we could see really troublesome levels of current account imbalances while speculative frenzy in financial markets may well produce sharp and painful corrections in asset prices.
Understanding when inflation is a problem