Inflation or no inflation?

One of the biggest dividing lines in the views of investors for the coming years will be if the current crisis and the fiscal and monetary stimulus will lead to inflation. As I have said before, I used to be in the camp that expected inflation after the financial crisis but have changed my mind. What the aftermath of the financial crisis has shown is that monetary stimulus and QE do not end up in the real economy because the lending channel is broken and banks are reluctant to lend to businesses and households at low interest rates. It simply isn’t profitable enough to do that.

However, there are other channels that could trigger inflation and that we need to monitor:

  • Governments overstimulating the economy: Fiscal stimulus is the new game in town. With monetary policy practically powerless, fiscal policy and direct government investments have to be the main source of stimulus not just in 2020 but for years to come. Politicians who are not concerned about deficit pending (MMT anyone?) are likely to use increased government investment and government consumption as a means to stimulate growth. As we have seen for centuries, this opens up the pathway to overstimulate and overheat the economy and create excess inflation. This is clearly a risk that needs monitoring, but so far we have limited evidence that governments are overstimulating the economy.

  • Wage inflation: Unlikely to be a problem in the next couple of years while unemployment is high, but it could become a driver of inflation once we have reached full employment again and if we see a significant effort by businesses to abandon low-cost production centres like China or India (unlikely to happen, in my view).

  • Taxes and tariffs: An increase in tariffs for imported goods (e.g. through a trade war between the US and China or a no-deal Brexit for the UK), could lead to higher prices for imported goods, temporarily fuelling inflation. Similarly, tax hikes to reduce government budget deficits would lead to temporary spikes in inflation. However, these effects are transitory. For persistently higher inflation we would have to see a constant increase in tariffs or taxes, not just a one-time increase.

  • Permanent increase in bank leverage limits: The Fed has temporarily lifted leverage limits for US banks during the crisis to encourage them to lend more. If these measures were to become permanent, one could imagine a scenario where banks start to lend again, even if they are losing money on it. But the memory of the financial crisis of 2008 is so fresh that it seems almost impossible regulators would allow that to happen or banks would engage in massive lending at low margins.

  • Governments forcing money into the economy: This is arguably the biggest wild card, but during this crisis, governments have started to force banks to provide emergency loans to businesses and households. Governments would guarantee these loans and banks could not deny these loans to applicants. If such measures would become a permanent measure after the crisis, it would open up the possibility for politicians to manage the supply of credit and money directly (thus circumventing independent central banks). While this is so far not on the agenda, it is a risk that needs to be monitored. In particular, one would have to consider how the central bank reacts to such measures. Would the central bank become more restrictive to neutralise the inflationary effect of such mandated loans? How would politicians react to a central bank directly thwarting their politically driven lending programmes?

Clearly, politicians using government policy and regulation to increase government spending or force money into the real economy are the biggest wildcards. I don’t think politicians will be reckless enough to fall into these traps, but the last five years have shown that populism is on the rise, and “cheap credit for all” is definitely a policy that is likely to attract votes.

For now, though, all we can do is monitor how Covid has influenced inflation so far and how inflation is recovering in the aftermath of the crisis. In this respect, I am glad Adam Shapiro from the Federal Reserve Bank of San Francisco has developed a new freely-available dataset to track the impact of Covid-19 on US inflation. On a monthly basis, he calculates the inflation rate split into components that were heavily impacted by Covid-19 (e.g. retail prices, education, and entertainment) and components that are insensitive to Covid-19 (e.g. housing, food, health care). The great thing about this data is that it allows us to identify inflationary and deflationary trends even in the presence of the Covid-19 pandemic. The Covid-19 insensitive inflation rate should provide us with a good estimate where inflation would be without the pandemic. And here, the verdict at the moment is clear. If anything, we so far are in a deflationary phase and there is no sign of inflationary pressures whatsoever. The inflation rate of Covid-19 insensitive goods and services is just 1.6% at the moment – way below the 2% long-term target of the Fed.

Covid-19 sensitive and insensitive inflation in the United States

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Source: Federal Reserve Bank of San Francisco.