Life used to be so easy for central banks. A tweak here and a tweak there was all it took to keep inflation under control. Now they are creating money in unprecedented amounts and contemplating negative interest with only the sketchiest idea of how things will pan out. It is much more complex and much more dangerous, not least for central banks themselves.
The problem is that lockdown is affecting both parts of the economy. Keeping people at home and restricting their movement reduces the supply of goods and services, which would normally mean upward pressure on the cost of living.
Yet, lockdown is also reducing demand, because some workers are being laid off and others are getting less from government wage subsidy schemes than if they had been doing their jobs. Weaker demand normally pushes inflation down.
The challenge for central banks is to assess these two forces and work out what to do using their two main policy tools – interest rates and the buying, or selling, of bonds.
So far, the evidence is that central banks see lower inflation as the more immediate threat. The US Federal Reserve, the European Central Bank and the Bank of England have all massively increased their quantitative easing programmes, in effect printing money by buying government and corporate bonds.
In the US, the money supply is growing at it fastest ever peacetime rate and the Fed has dropped plenty of hints that there is more to come.
In the UK, the Bank of England is expected to expand its QE programme by at least £100bn – and perhaps by double that – when its monetary policy committee meets on Thursday.
Hardcore monetarists fear this will end in tears. Once the lockdowns are over and the world returns to something like normal, they say all the extra money sloshing around will lead to the sort of inflation levels that will destroy the credibility of central banks.
It would be wrong to dismiss these warnings out of hand. The QE programmes during the financial crisis of 2008-09 resulted in a sharp increase in asset prices – shares and property – if not in consumer prices.
But central banks fear a colossal depression and deflation today far more than rapidly rising inflation tomorrow. That is the right approach but it is still fraught with substantial risk.