Is it too soon to talk about inflation?
A rise in the cost of living may be closer than we think, argues Insight fixed income manager David Hooker.
In the short term, markets have understandably focused on the immediate impact of efforts to contain COVID-19 on economic growth. The global economy has experienced a ‘sudden stop’, and it is possible that the resulting recession will be deeper than that experienced during the global financial crisis. The excess capacity that has been created, including soaring unemployment, has led to concerns that, if anything, inflation will be too low, failing to meet central bank targets. This has allowed the deployment of easier monetary policy and quantitative easing programmes of vast scale.
Of comfort to both markets and central bankers will be the persistent lack of inflation that has existed for over a decade. With this trend now deeply embedded in market psychology, it is easy to extrapolate these conditions into the future. The pricing of many government bond markets reflects this, pricing in the expectation that central banks will fail to meet their inflation targets for decades into the future. In the longer-term, however, the political repercussions of today’s events may sow the seeds for a reversal of several trends that have underpinned this period of abnormally low inflation.
Has an era of deglobalisation begun?
Even before the current crisis, a reassessment of globalisation was underway, with the US administration using tariffs as a tool to incentivise corporations to prioritise domestic production. In light of recent events, and the rapid breakdown of global supply chains that has occurred, corporations are likely to question their own production models. The lower costs and efficiency of globalised, just-in-time supply chains have been shown to be highly vulnerable to shocks. As supply chains shorten, the higher labour costs involved in domestic production, combined with a need to maintain higher inventories and an allocation of resources where lowest production cost is no longer the primary driving factor are all likely to be inflationary.
Once the threat of COVID-19 has subsided, the political focus is likely to shift to more closely scrutinise the initial weeks of the crisis. A senior UK official has been reported as stating that China faces a ‘reckoning’ over its handling of the outbreak. This could give momentum to perceptions that economies are over reliant on China for both trade and key areas of expertise. The 5G mobile infrastructure debate is perhaps a precursor of what is to come, with significant discomfort even before the crisis, in allowing Huawei, a Chinese technology company, to build key technology infrastructure. This may result in ‘national champions’ being used for certain infrastructure projects, with security replacing cost as the most important factor in allocating contracts.
Faced with higher debt burdens, governments may welcome higher inflation
In an era where central bank independence is becoming ever more questionable, a period of higher inflation may not actually be unwelcome for some politicians. The debt profile of many governments is likely to radically change in the months ahead. Lower economic activity will see revenues decline at a time when major fiscal stimulus packages are being implemented. In the US, the fiscal deficit was at elevated levels even before the crisis hit. Even in a scenario where the virus is contained and activity rapidly rebounds, debt to GDP will likely be markedly higher in coming years for many countries. Another period of austerity is likely to be difficult for many politicians to palate, and a period of debt eroding inflation may be more tolerable.
To add to this mix there is the unknown long-term effects of quantitative easing. Quantitative easing was introduced as a temporary measure post the global financial crisis, but has since become a mainstream policy tool for major central banks. Limited, gradual bond purchase programmes have evolved into unlimited shock-and-awe policies, extending into corporate bonds and even equities in Japan. The effects of quantitative easing are poorly understood, in part because standard models of monetary policy predict that it doesn’t work. When governments have monetised debt in the past, inflation has always followed. In the future, we may look back at today’s central bank purchases and wonder why it wasn’t considered to be debt monetisation.