Inflation after the pandemic: Theory and practice

Charles Goodhart 13 June 2020



“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”  Thus, wrote Milton Friedman in 1970 (The Counter-Revolution in Monetary Theory).  And for much of the rest of the last century that doctrine was treated as almost self-evident, and taught in most macroeconomic classes at our universities. 

Of course, there are many qualifications, to many of which I contributed in my role as a Bank of England economist at the time.  Let us take three such:

  • First, the money stock is endogenous (even monetary base in a world where central banks use the short-term interest rate as their primary instrument).  While inflation requires monetary growth to facilitate and enable it, it may not be the ultimate cause of that pressure. Using monetary measures alone to offset inflationary, or deflationary, pressures may be somewhat of a blunt instrument, and sometimes with undesirable side-effects, whereas focusing on the treatment of the deeper causes, though in concert with complementary monetary measures, could be preferable.  
  • Second, there are numerous definitions of monetary growth, and they frequently move in divergent ways. 
  • Third, and related to the second qualification, the velocity of each, or any, of these can change quite dramatically, even over short periods.  An obvious example of the latter is the total collapse of the velocity of M0 in the aftermath of its huge expansion, via quantitative easing, following the Great Financial Crisis (GFC), in some large part because a combination of interest on excess reserves (IOER), regulation and a desire for liquidity moved commercial banks into a liquidity trap, where they were prepared to mop up excess reserves almost without limit, thereby disrupting the transmission mechanism to the broader monetary aggregates and the real economy beyond.  

We are, of course, currently in a context where the velocity of broad money is dropping just about as fast as its overall supply is being expanded.  This arises from a combination of massive involuntary saving (people cannot go on holiday, attend theatres, buy new clothes, etc.), equivalent falls in the incomes of those supplying such services (offset by various forms of fiscal expansion, such as paid furloughs), and precautionary savings.  Yes, indeed, but that will not last.  Sometime in the foreseeable future, shops, hotels, even theatres, will reopen and the related workers will be rehired.  At this point, velocity will revert back towards normality.  And what then?

The correlation between monetary growth and inflation has an historic pedigree as long as your arm. Rejecting the likelihood of (eventually) rising velocity following the current massive monetary expansion requires an alternative theory of inflation that has successfully eluded all of us thus far.  Ignoring the potential inflationary dangers is the equivalent to an ostrich putting its head in the sand. 

But to mix my metaphors, our typical central bank ostrich has another barrel to their gun. Thus, our typical central bank ostrich will say that, even should there be some resurgence in inflation (and it goes beyond a welcome offset to prior undershoots), “we know how to deal with it”.  That position strikes me as an a-historical one, perhaps a consequence of economic history in our universities being relegated to a subsidiary status compared, for example, to mathematical mastery of DSGE models. 

Even if the path towards disinflation is well known, it simply isn’t available today. The great difficulties that central banks had in raising interest rates sufficiently to conquer inflation in the 1970s are a stark reminder of the difficulties of lowering inflation.  Remember Arthur Burns’ (1979) “Anguish of Central Banking”.  It took the alignment of three key people – Steve Axilrod, a master monetary tactician/strategist at the Fed; Paul Volcker, a brave and determined Fed chairman; and Ronald Reagan, an understanding, patient and competent president – to bring off that difficult exercise, and what a difficulty it was!  Nominal short-term rates went above 20% and real short-term rates were above 5%; there was a short-sharp recession; many less developed countries got into massive difficulties and almost defaulted; and the global systemically important banks were almost all, on a mark-to-market basis, insolvent.  And that was at a time when the debt ratios, both in the public and private sectors, were far, far lower than today.  Should we see inflation come back, and become expected – if only for a relatively short period of years – at a time when unemployment is likely to remain quite high and the debt ratios have gone through the roof, with over extended and fragile financial markets, is it really sensible to expect that central banks would be politically and socially allowed to raise interest rates on their own account sufficiently to bring inflation back to target?  After all, the vaunted independence of the central bank remains in the gift of each national government, except in the case of the ECB where it is protected by a treaty.  But even there, should the ECB try to take back the subsequent inflationary surge by sharply raising interest rates, it would be sensible for the Mayor of Frankfurt to invest in equipment to deter riots and demonstrations.  

Indeed, in the context of massive government deficits, and debt ratios rising sharply over 100%, (well over the level of Reinhart and Rogoff feared would normally cause serious economic problems), we may need to rethink how to adjust and protect the concept of central bank independence.  A few brave economists have begun to think along such lines (e.g. Bianchi 2020, Cukierman 2020).  I happen to believe that there are other and better ways to make such adjustments.  But that is for another column.


Bianchi, B, R Faccini and L Melosi (2020), “Monetary and Fiscal Policy in Times of Large Debt: Unity is Strength”, CEPR Discussion Paper 14720. 

Burns, A (1979), “Anguish of Central Banking”, 16th Per Jacobsson Lecture Belgrade, 30 September.

Cukierman, A (2020), “‘Covid 19: Helicopter Money & the Fiscal Monetary Nexus”, CEPR Discussion Paper 14734.

Friedman, M (1970), The Counter-Revolution in Monetary Theory.



Topics:  Covid-19 Monetary policy

Tags:  COVID-19, inflation, Central Banks

Emeritus Professor in the Financial Markets Group, London School of Economics


CEPR Policy Research