Inflation: down but not out

09 October 2020

8 minute read

In the wake of the pandemic and the US Federal Reserve’s (Fed) new inflation-targeting framework, Barclays Investment Bank hosted its 24th annual global inflation conference on 5 October. Inflation seems to be a topic of continued importance for investors and policymakers as we try to understand why it has been so low for so long despite huge central bank efforts. In this piece, we review the key takeaways from the conference and share our views on the outlook for inflation.

The weak inflationary impulse in recent years, at a time of ultra-low interest rates, has led many to question whether inflation is dead or is just hibernating. In order to evaluate the answer, it is worth reviewing how disinflation has emerged over recent years.

A key reason for the inflation path is the crucial role that central banks played in bringing down the inflation rate and then keeping it there. However, if this was the whole story, why have central banks found it so difficult to bring inflation back to the target rate after successfully lowering inflation?

Impact of globalisation

Largely explaining the paradigm shift, and something we discussed in Markets Weekly in August, may be globalisation. More internationally-connected trading relationships have meant that markets have become much more contestable, thereby eroding the market cost. What’s more, rises in input costs caused by exogenous shocks are unlikely to be a persistent step change in inflation as was so often the case in the past.

It seems reasonable to believe that inflation should be immune to the opening up of economies. China’s freeing up of its economy in recent decades added significantly to the pool of cheaper labour.

A clear outcome of globalisation has also been rapid technological advances which have shifted production to the emerging world and pushed costs down. A change that has reduced the pricing of labour and incumbent pricing through newer, cheaper and more competitive products.

Flattening the Philips curve

What’s more, and something that the Bank of England’s Monetary Policy Committee (MPC) member Jonathan Haskel argues, is that these technological advances could have helped contribute to a flattening of the Philips curve.

The curve examines the inverse relationship between inflation and unemployment. Traditionally the relationship has shown that as unemployment falls, inflation rises and vice-versa.

However, the link between inflation and unemployment has been much weaker for some time with the past cycle showing unemployment at record lows and inflation subdued, so flattening the curve. The link also appears to be weaker during lower periods of growth.

More central bank coordination

Ultimately, as former external MPC member Kristin Forbes argues, globalisation has enhanced substantially global value chains and has made inflation more of a global not a national problem. Something more akin to a global Philips curve would imply that a national policy measure may not be sufficient and global central bank coordination may be needed to help tackle the inflation dilemma.

Whether inflation is dead or hibernating will require a key distinction between short-run and long-run dynamics.

Short- and long-run effects

According to Claudio Borio, head of the Monetary and Economic Department at the Bank for International Settlements, over the following 1-3 years, or the short term, downward inflationary pressures are likely to prevail and the global economy should see excess capacity for some time. He believes that during such a period, any cost push pressures are likely to be temporary as opposed to permanent. This is something Haskel sees in the UK as well, in addition to the effect of spare capacity, household uncertainty and the fear of COVID-19 infection weighing on domestic inflation.

However, the story could be different over the longer term, with the legacy of the pandemic outstripping previous trends. A theme we talk about in our thematic article Globalisation’s ebb and flow is pushback from the globalisation of the past few decades.

Firms globally are cognisant of the disruption that this year’s periods of lockdown created to their globally-integrated supply chains and thus more inward movement is likely on the cards. China’s economic plans appear to favour such a movement in coming years.

Shifting political landscape

Furthermore, changes in the political environment, some of which appear to have taken place, may block international trade and foster a certain degree of de-globalisation.

Governments that have put up barriers to free trade have traditionally also tended to increase public debt and then seemingly relied on higher inflation eroding to some extent the increase in debt. Should this world emerge, inflation may have hibernated for a long time, but it is just hibernating and waiting to burst to life.

Central bank strategy

If the outlook on inflation seems uncertain, what more can central banks do to spark inflation to life and bring it back to target? Adam Posen, President of the Peterson Institute for International Economics, summarises the issue in football parlance in that “it is much easier to play defence than it is offence”.

Japan shows clear evidence of this with the Bank of Japan substantially increasing its balance sheet, keeping interest rates low and introducing measures such as yield curve control in the last decade. However, low inflation remains a cause for concern.

A shift in the Fed’s inflation review framework this year resulted in targeting the average inflation rate and implying that inflation could temporarily run above its 2% target. While it is a movement in the right direction, it is worth remembering that changing inflation targeting is a long process.

We can also see the struggles the European Central Bank faces in lifting inflation to its just below 2% target. Posen argues that the law of unintended consequences could be at play where factors such as the lack of real wage pressures and a lack of demand may also be key to unlocking inflation.

More fiscal assistance needed

The key takeaway from the above is that there is only so much that monetary policy can do. As such, central bankers have highlighted the importance of expansionary fiscal stimulus in conjunction with central bank support.

We have seen this during the pandemic.  The BIS’ Borio argues that the close co-ordination of monetary and fiscal stimulus was the shock that was needed and was effective as emergency conditions require emergency measures. Governments provided the demand for central bank purchases and helped to avoid a liquidity trap.

The spending taps, however, cannot remain open forever and may diverge from monetary policy due to high public debt ratios infringing on financial, macroeconomic and monetary stability. While fiscal dominance is a concern, Posen suggests that the limit to that level may be higher than in the past. The concern in terms of fiscal stability is servicing government debt, or what is the interest paid when debt rolls over?

Bias to overshooting target

Not only is this meaningfully lower than in the past, but upward inflationary pressures are unlikely to be met quickly with hawkish action by central banks. Faced with the risk of inflation overshooting its target in the short to medium term, or interrupting economic recovery after record contractions, central banks are likely to prefer the former to the latter.

Faced with the risk of inflation overshooting its target in the short to medium term, or interrupting economic recovery after record contractions, central banks are likely to prefer the former to the latter

Preparing for inflationary risks

Disinflation has led many to question future price pressures, if central banks have done all they can and if fiscal spending is reaching its peak. While the answers to these questions is uncertain, it is likely that inflation may come out of hibernation to some extent at some point.

A move away from global integration, fiscal policy altering consumer spending and circulating the economy will not happen overnight but appears to be on its way. Additionally, central banks may tolerate any period of higher inflation more than previously to accommodate recovery from the economic effects of the pandemic. As such, there is potential for more upward movement in inflation markets and a higher inflation profile than in previous decades.

For investors looking to shield their portfolios from the risk of significantly higher inflation, they may want to consider active management and a preference for quality companies and assets that tend to outperform in inflationary environments such as real assets or inflation-linked bonds.

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