The economic destruction caused by the coronavirus pandemic has been both crippling and profound in equal measure. Over the past few months, we have seen shocking economic data releases, collapsing consumer and business confidence, surging unemployment claims, and alarming growth contractions.
While policymakers had little chance of halting the abrupt decline, they have none-the-less gone to extraordinary lengths to mitigate the pandemic’s impact, and avert longer-lasting economic scarring. Around the world, central banks have slashed interest rates, eased lending criteria and provided huge liquidity injections through quantitative easing (QE). At the same time, governments have addressed liquidity and solvency concerns through loan guarantees, tax payment deferrals and income support programmes.
While the virus’s impact will inevitably fade (hopefully sooner, rather than later), it is still likely that this crisis will have a lasting impact on the world economy. But what will be the impact on inflation, both in the short and longer term?
It is clear that in the near term, the collapse in demand resulting from the crisis has been profoundly disinflationary. Food and toy prices may have risen, but the collapse in demand has seen prices fall significantly for most other goods and services, such as oil, electricity, clothing, hotel rooms, travel bookings etc. Indeed, recent data releases show just how dramatically this is the case through inflation. The US consumer price index (CPI) declined -0.8% in April, the largest monthly fall since December 2008 (another month of crisis), while the UK saw a similar outcome, with April’s CPI falling -0.4%.
Other factors are likely to continue to suppress inflation over the coming quarters. The extraordinary level of job losses seen over recent months has created a labour market that benefits employers and, even as the economy regains traction, wage growth is likely to be subdued as workers compete to find work.
The speed and severity of this crisis has been a huge shock to both corporates and consumers, and exposed how little is held in reserve for a ‘rainy day’. It seems likely that a more reserved attitude towards consumption, investment and debt will be adopted by everyone. The consequence of this shift may be more restrained spending patterns in the future. We last saw this in the aftermath of the 2008/2009 global financial crisis, when savings ratios rose dramatically, as both corporates and consumers worked to reduce borrowing and strengthen their financial positions.
Although in the near term, there is little doubt deflationary forces will dominate, the picture is much less clear the longer the timeline, as there are a number of factors that could cause inflation.
One of the lasting legacies of the pandemic will be the dramatic increase in government debt levels. With spending up and tax receipts down, some economists estimate that the average G7 government debt to GDP ratio will rise to a staggering 140%, before eventually stabilising. In normal times, fiscal and monetary policies, such as those currently being pursued, would typically lead to inflation. This is because they tend to debase currencies, expand the monetary base and fuel excess demand.
However, we live in strange times, and there is no immediate prospect of that outcome ‒ even though it would be easy to misjudge how far these policies should be taken. History is littered with examples as to how governments printing money has led to a debased currency and hyperinflation. Certainly, there will be a temptation by authorities to do too much, rather than too little, as there is a general belief that it is easier to rein in excessive inflation than to combat embedded deflation. If the policymakers of the eighties and nineties mainly feared runaway inflation, the focus of the current generation is the fight against disinflation. Indeed, some governments and central banks could welcome a period of higher inflation as it would help erode the real value of their growing debt mountains and correct a persistent inflation undershoot.
Before the pandemic, globalisation was already in retreat ‒ and this period has probably put the final nail in its coffin. For a long time, increased global trade boosted growth and subdued inflation. As advanced economies allowed lower valued jobs to move offshore to emerging markets, the real cost of manufactured goods fell, even though there were social consequences of growing inequality.
This negative side of globalisation contributed to a rise in nationalist and populist tendencies, fed by slogans such as Trump’s “Make America Great Again” or the Brexiteer’s “Take Back Control”. After many years of falling tariffs, they are now re-emerging as a weapon of choice between nations in dispute. Tariffs can be effective tools to punish trade adversaries, but ultimately they are self-defeating as they act as a tax on consumers and raise the price of goods and services.
Another legacy of the pandemic is there will be a degree of capacity destruction in some, if not all, industrial sectors. Many businesses may never reopen their doors, especially those in the retail, hospitality and travel industries. Reduced supply may well lead to rising prices as competitive pressures ease and survivors regain pricing power. For example, if a few airlines go bankrupt, we may well see ticket prices rise in response due to less supply and competition.
Last, but not least, the pandemic has also called into question an over-reliance on complex and long supply lines. As a result of difficulties experienced over recent months, it may be that some companies choose to realign their arrangements. The crisis seen in national health services over simple personal protective equipment (PPE) served to highlight the risk of being overly dependent on foreign companies in distant lands for essential items. However, while the PPE shortage made headlines, it was not the only example of supply-chain issues. Who knew that China controls 90% of the active ingredients used in antibiotics? Given the pandemic has exposed the vulnerabilities of complex supply chains, many now argue that future disruption can only be avoided by sourcing closer to home. Of course, if this becomes widespread, all the benefits of globalisation would be reversed, and the cost of many manufactured goods would rise.
In conclusion, we have highlighted a number of factors that could add to inflation over the longer run. We do not believe that QE, the 21st century’s version of copious money printing, is likely to lead to a period of rampant inflation, such as occurred in the seventies and early eighties. Technology and updated working practices have undermined the power of unions and collective wage bargaining, making it unlikely that double-digit annual wage increases will return.
Massive shifts in exchange rates are also unlikely to have a significant bearing on inflation, since all countries are meeting the same challenges with similar policies. Exchange rates are a relative game, and it’s pretty hard to pick winners and losers when all the runners are so evenly handicapped. With bond yields at historic lows, the implications are financial markets see little prospect of inflation rising back to anywhere near the 2 to 2.5% levels central banks typically target.
In this respect, we believe financial markets are mispricing longer term inflation, and in the fullness of time, inflation will return and may be allowed to sit at higher levels than the recent past to help governments manage down the real value of their debts. For investors holding long dated government bonds that today offer either a negative or near zero yield, while they may not need to rush for the door quite yet, there is a risk that over time yields will drift higher. This would leave them nursing capital losses. At Nedbank Private Wealth, we prefer to protect against this risk by favouring bonds with a shorter duration that are better shielded from interest rate risk.
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Louis joined in July 2019 as an investment analyst in London, focusing on quantitative analysis and fund research. He has also worked for Investec, Capgemini and Wesleyan as an intern. Louis holds an MSc in Finance from the London School of Economics and and a BSc (Hons) degree in Economics from the University of Birmingham.
Madhushree joined in December 2015 as an investment analyst in London, focusing on macroeconomic asset allocation and fund research. Madhushree holds an MSc in Investment and Wealth Management from Imperial College Business School and a first class BSc (Hons) degree in Banking and International Finance from Cass Business School. Madhushree is also a CFA Charterholder.