COVID-19 crisis: Japanification or high inflation?

In the short-term, the COVID-19 induced recession should have a deflationary effect on the global economy. As is the case with every recession, weaker activity, coupled with excess production capacity, usually causes price growth to slow, if not deflate. On this occasion, the compounding effect of sharply lower commodity prices is also set to depress headline inflation.

The above view is widely shared among US households, another worrying sign. The University of Michigan runs a monthly consumer sentiment index, based on a nationally representative survey, and assesses inflation expectations for the following 12 months. With this at 2.1%, the index has reached its lowest level since March 2009.

Will monetary stimulus help avoid deflation?

In the space of a month, central banks responded to the pandemic by cutting interest rates and setting up programmes to pump more liquidity into the economy. For instance, the US Federal Reserve’s (Fed) balance sheet ballooned by $1.7tn. To put that into perspective, it took almost three years for the Fed’s balance sheet to expand that much between 2008 and 2011, in response to the Great Financial Crisis.

At the time, many economists feared that the quantitative easing would generate inflation. While US inflation never topped the 2.5% inflation target in the aftermath of the crisis, the size of the current monetary injection in the developed world is much higher than what was seen at the time.

Velocity of circulation is key

But the key to determine whether liquidity injections will be inflationary is the speed at which the money circulates in the economy, the so-called velocity. In periods of stress and uncertainty, cash becomes king and households, as well as companies, tend to hoard cash. The increase in savings means that velocity of circulation falls and this lack of money is compensated for through an additional injection from central banks.

Banks, through loans and credit, are a key agent when it comes to money circulation. In 2009 banks increased their capital buffers and restructured non-performing loans, or those on which the borrower is late making payments on.

This time, regulators are focusing on reducing the burden on banks in order to aid the flow of money in the economy. However, once a recovery starts, and the velocity begins to increase, there is a risk that the stock of money will be too large than is needed in the economy. This would likely cause inflation to rise. But considering the short-term risk of a deflation, central banks are not worrying about this potential outcome.

What about the supply hit?

Rather than the earlier, monetarist, approach to inflation, another way is to look at inflation through the lens of a supply-demand mechanism.

The fiscal measures being put in place around the world are mostly aimed at supporting demand, through loans, grants or social security benefits. This is happening when supply has been drastically reduced as most companies have reduced, or stopped, their activity. While most households are likely to increase their savings in the current uncertain environment and reduce their consumption, this reduction in demand should be assessed in relation to the likely fall in supply too.

Pandemic-related factors could trigger inflation pressure

COVID-19 is likely to reshape the way many businesses operate. Supply-chains will likely need to be reassessed and reliance on a single source for production inputs will probably be abandoned. Globalisation has helped cut inflation rates over the past 30 years. Any degree of reversal of globalisation would probably increase costs for most companies. A long period of social distancing could also make it more expensive to run a consumer-focused business, as the space per consumer has to be increased (think of business like restaurants, airlines and shopping centres).

Finally, a recent Working Paper from the Federal Reserve Bank of San Francisco paper, looking at the long-run economic consequences of pandemics, highlights that real wages tend to be somewhat elevated following pandemics.

Turning a blind eye

In most developed countries, the amount of debt as a share of economic output may supersede that seen during periods of war.

There is a key difference between wars and pandemics. While growth in the aftermath of a war is usually strong, as large investments are needed to replace destroyed capital, pandemic recovery does not call for such a response. While strong growth helped to reduce the debt pile after world war two, growth is unlikely to be strong enough to meaningfully reduce government debt this time around. For this reason, it is possible that authorities could turn a blind eye to inflation so it eats away at the, nominal, debt level.

What are financial markets expecting?

Equity and fixed income markets are taking a different view on inflation prospects. Equity prices have strongly rebounded since sharp falls seen in early March, seemingly discounting a quick, strong pickup in activity. Meanwhile, fixed income markets suggest that inflation will remain low for a long time.

The five-year, five-year forward inflation measure for the US, which measures what the market expects the inflation outlook to be over a five-year period, in five years’ time, reached an all-time low in March. The indicator implies that the market expect inflation to be low for the next decade (see chart).

While it is nigh on impossible to forecast long-term inflation, there are currently arguments in favour of adding marginal protection against inflation to a portfolio. Inflation-linked bonds, gold, infrastructure and real estate are among asset classes that have typically provided the best hedge against inflation.

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