By Andy Mukherjee
Inflation is coming. Or wait, it’s already here. Bond investors are looking at the 4.2% annual rate that U.S. consumer prices jumped to in April and wondering if it’s all because of depressed levels from last year. Could it be that the Federal Reserve is wrong about higher prices being transitory?
It’s a project best undertaken after price pressures have eased, and the vast pools of excess liquidity to fill the gaping economic hole left by the pandemic have dried. A premature contest to introduce a digital yuan, digital euro, FedCoin or BritCoin could see them emerge as widely accepted substitutes, not only for physical cash but for bank reserves. Tackling inflation could then get harder.
To see why, consider the typical response to unexpected inflation from a monetary authority that has done a lot of quantitative easing. It has to taper its bloated balance sheet by selling some government and corporate bonds to the banking sector, draining the excess reserves they’re keeping with the central bank. Less liquid lenders would, in turn, sell loan assets. Tighter monetary conditions would tame inflation.
Now, think of a twist in this standard playbook: You and I are free to convert the funds in our bank accounts into electronic cash issued directly by a monetary authority. Commercial institutions lose our deposits, but if they aren’t bothered about becoming a little less liquid, they won’t sell income-earning loan assets to compensate. Instead, they may shed another asset to balance their books: their idle cash with the central bank.
The monetary authority now owes a little less to commercial banks, and a little more to us. The size of its balance sheet hasn’t changed, and the tapering it wanted to achieve by selling bonds to the private sector hasn’t occurred. Digital cash “renders the current asset-purchase programs quasi-permanent, as reversing such programs becomes harder to implement,” says a recent study by researchers at the Swiss Finance Institute.
Central banks in China and Sweden have fairly advanced plans to introduce currencies in electronic form for retail use. Other major economics are toying with the idea or conducting experiments. None that I know of foresees digital cash to replace bank reserves.
The immediate goal of national authorities is to tamp down the cryptocurrency mania by giving citizens a safe, sovereign alternative to Bitcoin — something that Elon Musk can’t refuse to accept as payment for a Tesla. For China and the U.S., though, the motivation behind launching digital cash extends to challenging — and defending — the outsize role of the U.S. dollar in the global economy.
Whatever their reasons to offer electronic currencies, the return of global inflation shows that caution is warranted. Record low yields on junk bonds is one indicator of the surplus cash floating around. Global liquidity has risen by $32 trillion over the past year, equivalent to more than a third of world output, according to London-based Crossborder Capital Ltd., which estimates that another $15 trillion is slated through the end of 2021. In its quest to maximize profit, a part of the commercial lending system could easily jettison the parachute of sticky retail deposits — allowing them to turn into digital cash — without selling risky assets. The pursuit of profit by sacrificing liquidity usually ends with socialization of losses: expensive, taxpayer-funded bank rescues.
The trajectory and persistence of inflation needs a close watch. Maybe the combination of aggressive fiscal stimulus and generous monetary easing has managed to release the price genie out of the bottle — something that quantitative easing alone couldn’t do after the 2008 financial crisis. If that is indeed what we’re witnessing, then monetary authorities should hope that public reception to digital cash remains like it is in China’s pilots right now: lukewarm. Anything hotter would be risky.