Is there any reheating scenario?

It is not the most likely scenario, but is nonetheless worth a ponder, as I outlined in my latest Bloomberg column:

Consider a simple scenario involving output and money, much of which takes the form of credit expansion by banks and other intermediaries. In a well-functioning economy, money and output grow at roughly the same rate.

When economies experience turnarounds, however, conditions on the ground can change rapidly. In such circumstances, the growth of the money supply might outpace the growth in output — even if the central bank does not intend such a result. The reason is that output can take a while to grow. Businesses might have to expand capacity or hire more workers, and right now there is still a labor shortage. Even when an economy is functioning well and business conditions are good, output often grows with a lag.

The money supply, however, need not suffer from a lag. Banks, for instance, can extend credit quickly if they foresee that a recovery is stronger than expected. Even if a bank is in the midst of processing a loan, it can simply lend out more than it was planning.

Thus there can be periods when, for entirely natural reasons, the money supply is rising faster than output. That situation requires only a sudden burst of good news. And indeed there has been exactly that with the recent favorable inflation reports and the surprisingly good recent GDP report. The irony is that a positive market response to low inflation and strong growth cheers up market participants and could lead to … a new dose of inflation.

Another possible pathway for these scenarios involves interest rates. During a normal disinflation, the Federal Reserve raises rates and keeps them high for a long period of time while the economy adjusts slowly — often passing through recession. But inflation has fallen more rapidly than expected, and so the market may expect the Fed to lower interest rates sooner than planned. And an expected cut in interest rates can encourage expansionary pressures just as much as an actual cut in interest rates.

It is a funny world in which slow inflation can cause faster inflation. It’s the logic of expectations that makes it possible, albeit far from certain.

Inflation isn’t going back up to where it was, but please do keep in mind that numbers can move in both directions.

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