Written by Gary Smith
Forecasts of where the inflation rate might go have rarely been as dispersed as they are today. The economic consequences of the COVID-19 pandemic have led simultaneously to forecasts that we are heading into a period of deflation, but also to forecasts that over the medium term we could see inflation rates of 10% or higher. Whichever view proves to be correct, it seems as though a decade of stable inflation rates may be coming to an end.
Let’s begin on what economists actually agree on. Most accept that over the short term the consequence of the global collapse in consumer demand will be a decline in inflation rates, and possibly even a move into deflation. The collapse in demand will leave a surplus of supply in many sectors and there will be immediate downward pressure on prices. The oil price collapse is a good example of this, and was a key input into the declining headline inflation rates for March that we have seen in all but two of the G20 nations. Most economists agree that further declines in headline inflation rates are likely into the summer, but there are significant differences of opinion on how the data might evolve over the next 12 months.
The inflation bounce camp have highlighted several factors. Firstly, they expect to see a trend for global supply chains to be reversed. Bringing production back to a home nation would likely mean higher costs in terms of labour and materials, and could also lead to a need to maintain permanently higher inventory levels. The “just-in-time” model will be gone, and so will its low cost benefits. In a re-shoring scenario the management threat to shift jobs to lower cost foreign nations will end, and bargaining power will swing back towards workers and away from employers for the first time this century.
Secondly, this camp highlight the policy announcements from central banks and governments announced in recent weeks. They expect a surge in the supply of money in the economy, and as the textbook tells us, “too much money chasing too few goods” will result in higher inflation. Although we heard something similar in 2009, it is now argued that quantitive easing in 2009 became clogged in the banking system. In monetarist language the boost was confined to narrow measures of money, not the wider measures of money which are more relevant to activity that takes pace outside the banking system. It is argued that some of the recently announced measures such as the financial safety nets for corporates and workers will boost the wider measures of money supply.
The inflation surge argument hinges on a three key factors. The first is that back in January 2020 the global economy was operating at close to capacity, and secondly that a V-shaped recovery occurs this summer. In this scenario the recent policy response would prove to have been strongly pro-cyclical, and a recovery in demand would swamp available supply. Higher inflation rates would inevitably follow. The third aspect to the argument is that any jump in inflation rate would be tolerated partly to compensate for several years of inflation undershoot, and partly to build an economic buffer and reduce the risk of a fresh crisis.
The higher inflation camp also point to longer term stories, such as the consequences of demands for a more redistributive tax system. They point to the US presidential election as a possible pivotal event, and highlight that increasing the tax burden on the the very wealthy (who generally save more), in favour of the less wealthy (who spend more of their disposable income) will help to give the demand for goods and services a fillip.
Finally, inflationistas point out that the price of oil is unlikely to collapse any further, and hence the year and year comparison (an important measurement tool) will almost certainly show a positive oil price inflation number by March 2021.
The main points made by the low inflation, or deflation, camp can be summarised as follows;
They do not believe that a V shaped economic recovery is likely. They argue that the collapse in demand has already been so severe that a situation of excess supply will persist for many months. Furthermore, they argue that flattening the curve of COVID infection is more consistent with an L shaped economic recovery. They foresee each easing in lockdown rules allowing more oxygen to get to the fire that is the pandemic, extending its duration and increasing the chance of a second wave of infections. This “manage but prolong” scenario will mean there will not be a magical day when the crisis ends and a spending splurge commences. In this scenario much postponed discretionary spending will in fact become lost forever.
If re-shoring does indeed lead to the higher prices that the hawks suggest, will that have an impact on demand? Will people pay £30 for a U.K. produced shirt when last year something similar from Vietnam cost £15? Many of the newly unemployed may reflect on where the cutoff point between “like to have” and “need” is now located. In an environment of weak demand, price increases for non essential goods that result from re-shoring may be reflected more in ticket prices, than at shopping tills.
The first two decades of this century were characterised by inflation rates repeatedly undershooting both market expectations and in many cases, central bank targets. If this trend is going to change, the functioning of the labour market, and wage inflation trends in particular, will be the critical. The deflation camp point out that unemployment has rocketed, and they do not believe that a strong wage push is coming, even if the reshoring economic pattern plays out as described by the inflation camp.
Elsewhere, the doves highlight that the first round of fiscal measures appear to have led to an increase in savings, both involuntary and precautionary. A desire for increased savings does not support the argument for a strong economic bounce back, and a collapse in consumer and business spending will reduce the demand for bank credit that makes up the majority of the broad money supply. Those fearing deflation tend to search first for the likely demand for credit, rather than the availability of credit. Money supply expansion will achieve little without demand.
In terms of the tax system, the focus of the deflation camp is on the overall burden. Government spending has been ramped up in a way never before seen in peacetime. Who is going to pay for the massive increase in debt? It seems likely that the tax burden is going to be increased at some stage, and will become a demand dampening factor when that happens.
Finally the low inflation camp has also warned that we need to be wary of measurement dislocations. For example, although a reduction in the number of aircraft seats that are made available on flights (to ensure social distancing) may lead to sharply increased cost of an individual seat. However, the demand for flying is going to fall sharply if the airport experience turns into a five hour ordeal involving medical checks at either end. Such a decline in demand for air travel will eventually be reflected in a revised CPI basket. In other words, the inflation impact of higher prices might be entirely offset by a lower weight in a revised basket. However, be warned, basket weight revisions are currently only carried out annually.
In looks as though the long run trend of stability in the inflation rate is ending, and that we need to prepare for an inflation rate roller coaster.