Many believe that once economic activity normalises, the combination of stronger demand (as a result of ongoing loose monetary and fiscal policy) and constrained supply (as a result of Covid-19’s impact on supply chains) will result in higher inflation.
We disagree.
Supply side issues may put upward pressure on inflation as firms look to build more resilient supply chains. However, demand will remain weak as governments tackle debt built up during the pandemic, and corporates and consumers remain cautious about spending. Passing on higher costs will be difficult and firms will pursue technological solutions with greater vigour. Moreover, we don’t think the authorities will use inflation as a way to solve debt problems; doing so would require a regime change and is likely to be politically unpopular.
Initial signs point to deflation
The initial signs are that the coronavirus crisis is having a significant deflationary impact on the world economy with both activity and inflation falling sharply. The collapse in demand has hit oil prices, leading to lower energy costs whilst we have seen a deluge of offers from retailers keen to clear the excess stock which built up during the lockdown. As airlines and hotels re-open we can expect more discounting and would not be surprised to see headline inflation rates turn negative in the US and Europe in coming months. The drop in commodity prices has been similar to that experienced in the last recession and the mid-cycle slowdown of 2015, and signals a period of sustained weakness in US inflation in coming months (chart 1).
However, as people get back to work and activity improves, many are looking ahead to the next phase of the cycle and foresee a spell of inflation. Stronger demand fuelled by loose fiscal and monetary policy could drive prices higher as the world economy normalises. In particular the acceleration in money supply in the US is seen as a harbinger of higher prices; here we have seen extraordinary growth in M2 – a measure of cash deposits, and other liquid instruments including mutual funds. Taking account of the potentially disruptive impact of Covid-19 on the supply side of the economy, some now see a watershed between the low inflation of the past 30 years and a more volatile period where inflation picks up significantly.
Such an outcome would mark a significant shift for markets where low inflation has become embedded in asset prices. It has enabled central banks to keep interest rates low and also allowed them to respond freely to demand shocks with looser monetary policy. The so called “Fed put” (or belief that the Federal Reserve can always lower interest rates to rescue financial markets) has played a key part in supporting risk assets, but has only been possible as a result of the leeway created by low inflation.
So how great is the risk of a significant shift, or a watershed in the behaviour of inflation?
Concerns over a pick-up in inflation are not new. The introduction of quantitative easing (QE) in the US in 2008 was greeted with warnings that money printing would lead to rapidly rising prices. In the event the concerns were misplaced as, after a commodity-driven bounce in the early stages of the recovery in 2011, global inflation fell back and spent most of the past decade below 2% in the US and eurozone. The problem for central banks has been too little rather than too much inflation.
Will it be different this time?
Despite Milton Friedman’s famous dictum that inflation is always and everywhere a monetary phenomenon, the relationship between measures of the money supply and inflation is loose at best.
Rapid accelerations in the money supply are frequently accompanied by equivalent declines in the speed with which money circulates in the economy (known as velocity) to leave overall activity little changed.
The decline in the velocity of circulation after the global financial crisis meant that despite the rise in money growth, inflation did not pick up in response to QE (chart 2). Instead the extra money created remained in the banking system which saw reserves rise significantly in the wake of the crisis. It did not feed into the economy and price levels.
Some argue that this time is different as the money created by QE is being fed directly into the economy through increased fiscal spending. However, whilst it is true that central banks are creating money and buying government bonds almost as rapidly as public debt is rising, this is not the same as printing money and spending it directly in the economy.
QE purchases are made in the secondary market from investors (such as insurance and pension funds) rather than directly from the government through the primary market. The extra liquidity created by QE is going to investor accounts and bank reserves as before. QE helps keep borrowing costs down, but does not directly fund governments in the way that policies such as modern monetary theory (MMT, sometimes dubbed “people’s QE”) advocate.
Certainly the scale of QE is larger than in the last recession, as are the increases in budget deficits, but this needs to be seen in the context of a much greater collapse in demand. The government has stepped in to pay wage bills and facilitate loans to keep businesses afloat that would otherwise have failed as a result of the lockdown and cessation of cash flow. The significant falls in GDP which have accompanied the policy and rise in public borrowing bear this out.
In effect governments are acting to cushion the economy against the impact of the lockdown rather than adding extra demand. Similarly the increase in corporate bond issuance and lending to companies is not in response to stronger corporate activity. Instead, it reflects attempts to offset lost cash flow, to cover fixed costs, and to build a war chest to get through the lockdown period.
The important point is that the act of QE does not induce households and companies to go out and spend more. Those decisions largely depend on confidence in the future which in turn is driven by the strength of incomes and balance sheets alongside innovation and technology. From an inflation perspective, QE has had little impact on household price expectations which have continued to decline throughout the QE era – a key factor in containing wage growth (chart 3).
Roads to higher inflation
There are many arguments for the return of inflation. We tackle some of them below.
- Overdoing it: excess fiscal and monetary stimulus
The ability of QE to boost the money supply but little else, does not rule out higher inflation in the future. Going forward as activity recovers there is a risk that policy measures – fiscal as well as monetary - will be left in place for too long and will overstimulate the economy.
Politically there will be a temptation to ignore budget constraints and keep the foot on the accelerator so as to leave the pandemic behind and get the economy back to full employment. Clearly this is a risk and given the uncertainties as we emerge from the pandemic, by accident or design, policymakers could make an error.
However, this would require sustained and significant spending to close the output gap (the difference between an economy’s potential and actual economic output) and create inflation.
Economic slack is significant; unemployment rates have risen to post-war highs with US unemployment at 13.3% in May. We expect the US output gap to reach 9% of GDP this year compared to a previous low of 6.5% in the global financial crisis (GFC). Jobless rates in Europe have not reached US levels, but mainly as a result of furlough schemes; consequently these disguise the potential slack in the labour market.
As lockdowns are lifted, jobless rates should decline sharply; however, it is likely that spare capacity will persist as a result of a slower pace of demand. After the initial burst of pent up expenditure (see the May US retail spending figures for example), we expect consumer and corporate caution to increase on concerns of a second wave of infection and a loss of job security – a factor which will limit the pick-up in spending.
Structural shifts also mean sectors such as travel, tourism and hospitality will be less viable as a result of regulations in the post-pandemic environment. For example, airlines are already recognising the long run impact and are restructuring their workforces. Knock-on effects to manufacturing from cancelled orders are causing a ripple effect on employment across the economy. Such scarring effects mean that spare capacity is likely to persist and weigh on inflation.
- The impact of a hit to globalisation and productivity
Looking further ahead, it is likely that there will be effects from Covid-19 on international supply chains and that the pandemic will be a further hit to globalisation. Global trade has been falling as a share of activity since the GFC and saw a further set-back during the trade tensions of 2019.
Covid-19 could accelerate the process of de-globalisation by highlighting the fragility of supply chains. It is also likely to constrain the flow of labour between countries. From this perspective, Covid-19 could help reverse one of the dis-inflationary forces in the world economy.
Once activity normalises, we can expect that firms will look to increase the resilience of their supply lines such that a shutdown in one country does not cause the whole chain to fail. There is a case for smaller, but more geographically dispersed plants where production could be stepped up to offset losses elsewhere.
Similarly, companies will question the “just-in-time” model of holding skinny inventories which leave little scope for disruption. Such changes can make supply chains more resilient, but at a cost as the extra slack in the system results in a loss of efficiency. Those higher costs can then lead to higher inflation as firms attempt to pass them on to consumers.
Similarly, at a more domestic level, the service sector is facing a significant cost in re-opening with restrictions such as social distancing limiting the flow of customers through retail outlets, in cafes or on airlines, for example. For those sectors, labour productivity will be lower and unit wage costs higher, so creating the prospect of higher prices and lower output i.e. stagflation (when lower economic growth is accompanied by higher inflation).
Wage rates could also accelerate as a result of the slowdown in migration, which will reduce the supply of labour and hit economies such as the UK particularly hard.
These factors do point to some upward pressure on inflation over the medium term, but they have to be seen in the context of weaker demand as over the same time horizon governments will have to tackle the increase in debt built up during the pandemic.
For the G20 group of advanced economies the level of government debt is set to exceed 130% of GDP on IMF projections this year (chart 4), higher than the level reached in World War Two. Debt deflation will weigh on activity as governments de-lever, a task which will be made more difficult by increased demands for greater spending on healthcare in the wake of the pandemic.
Greater automation would lead to lower prices
We highlighted the increased pressure on government finances in our recent update to the Inescapable Truths where we also argued that the experience of the pandemic would accelerate the adoption of technology and the fourth industrial revolution. Faced with the need to build more resilient supply chains without a loss of efficiency, companies will increasingly turn to automation and particularly the combination of robotics and artificial intelligence (AI). Such action could also solve the problem created by potential shortages of labour as migration slows.
It will take time, but ultimately the increased use of technology could lead to greater productivity in the economy and lower prices. More immediately the deflationary effect of technology marches on: according to Empirical Research Partners, Amazon has accelerated capacity growth to satisfy the surge in demand it saw during the crisis. “The company is adding 40 million square feet to its US fulfilment centre fleet this year, twice the pace we’ve seen in prior years. The selling capacity Amazon is adding this year alone is greater than the pre-pandemic size of Macy’s, J.C. Penney and Kohl’s put together”.
The shift toward online retail has been accelerated by Covid-19 and along with it, intensified competition and disruption for the retail sector.
Using inflation to solve debt problems will require a regime change
The effect of the pandemic on globalisation is complex and firms will face hard choices in trading off resilience against efficiency in re-setting supply chains and restoring productivity. Technology is still a powerful deflationary force though and has been given a boost by the pandemic, even though it will bring more disruption in its wake.
The other clear challenge for the world economy will be in bringing government debt down after the pandemic ebbs. We see this as a drag on future activity, but many take the view that the challenge of bringing down debt whilst meeting growing demands on public finances will inevitably result in governments creating inflation to erode the burden.
Politics will not allow austerity and tax increases are too unpopular particularly as populist pressure is likely to continue to rise. Consequently governments will have no option but to turn to the printing presses and directly fund deficits.
Such an outcome is possible, but this route to higher inflation would require a regime change. Out would go independent central banks and inflation targeting and in would come MMT and fiscal sovereignty over central banks and monetary policy.
The loss of central bank independence would be critical. As the IMF correctly argued at a similar point in the last economic cycle: “Looking to the future, our analysis suggests that ongoing monetary accommodation is unlikely to have significant inflationary consequences, as long as inflation expectations remain anchored. In this regard, preserving central banks’ independence is key”.
In our view, financial repression rather than inflation is a better route to bringing down debt. Moreover, inflation is never politically popular as the UK experience of the 1970s and numerous emerging economies have demonstrated. Given demographics and the importance of the inflation-sensitive pensioner vote this is more true than ever.
Those looking for higher inflation to solve debt problems should be careful what they wish for.
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