Author – Trevor Hubner
One of the intriguing aspects of the past few years of extraordinary central bank policy, has been the relative absence of inflation. Generally speaking, low interest rates should encourage borrowing which increases money supply and consequently cause inflation. However, this has not been the case over the past decade and now many commentators are beginning to think about when we may see its return. When considering this it is important to realise that inflation is an effective way of eroding debt and, with government borrowing hitting stratospheric levels, a degree of inflation would help with this situation, but it would need to be closely controlled and that is not the easiest process.
Inflation is basically excess demand over supply, in other words more people are chasing fewer goods and prices rise accordingly. As with most aspects of life, COVID has very much affected this balance and looks likely to continue to do so. Since March, supply has dropped as factories closed down and transportation ground to a halt. However, at the same time demand also dropped as consumers stopped spending in lockdown, in fact demand dropped by more than supply which is disinflationary. Furthermore, the price of oil fell sharply as demand
collapsed at a time when there was already oversupply. As energy accounts for 5% to 7% of the inflation figures in Europe this also kept a lid on any real suggestion of inflation.
As lockdown restriction are eased and the situation develops there are several factors that will come into play and, challengingly they will be pulling in different directions, making predictions incredibly difficult. But while it is impossible to predict exactly what will happen, you can try to outline potential scenarios and attempt to judge how these might affect inflation, or possibly deflation.
Firstly, as stated above, demand for goods dropped during lockdown, as people were unable to go out and spend money. This has resulted in pent up demand and consequently an increase in spending, evidenced by the recent bounce in retail sales. This demand has come at a time when the supply chain is still not back to full strength and so demand is outstripping supply, which is inflationary. However, this bounce back is very much in its infancy and there remains a big question mark over whether this continues. Much depends on government policy and its success or otherwise of neutralising the impact of COVID on peoples incomes by supportive measures such as the furlough scheme. The worry is that if support is removed too quickly there will be a negative impact, especially in terms of employment levels which will likely have a knock on effect on spending patterns. Further to this, if unemployment rises this will have a negative impact on wage growth as firms will be able to pay less to attract workers.
A second consideration is the likelihood of deglobalisation in the near future. Over the past decade, globalisation has made it hard to generate inflation as increased trade between countries and lower trade tariffs, have kept costs and consequently prices down. This situation has been amplified by the wide adoption of technology and automation which again tend to be disinflationary. Post COVID this situation will quite possibly change as travel restrictions impede the flow of goods and trade disputes between nations such as China and the west intensify, increasing trade tariffs. While this would certainly be inflationary there is a question over how much the consumer will accept the higher prices caused by repatriating business to home. It is all very well advocating “Buy British” but when it comes down to hard earned money the consumer tends to look for value.
The third factor is going to be central bank and government policy and actions. As stated above inflation is an effective way of eroding debt but it is extremely hard to control. Japan have been in a low inflation loop for the best part of 25 years and indeed first started asset purchases (the precursor to Quantitative Easing) all the way back in 2002 in an effort to generate inflation. The fact that this didn’t work is a warning to the central banks now on the same path. With interest rates already low, or even negative it is hard to see how traditional monetary policy could be used to generate and importantly, control inflation. The answer may turn out to be further central bank intervention into markets, in addition to QE and yield curve manipulation has been suggested. The trouble with any of the so called “thinking outside of the box” solutions is that they don’t always work and frequently have unforeseen consequences in the longer term. Often the desire for things not to unwind in the short term is only storing up problems for the future.
As outlined above, it is impossible to state with any conviction exactly the trajectory or timing of any return of inflation, but it is a risk that many take seriously. The traditional inflation hedge is to hold gold and this is up around 25% over the past year indicating a run to the safe haven asset class. There is a danger that a younger generation that hasn’t experienced the problems of runaway inflation may be flippant about the effects it can have, but us older heads will continue to watch developments closely and try to adjust a portfolio accordingly.