Lack of confidence will restrain inflation

Figure 1 COVID deaths and GDP: no trade-offs

As countries report their latest 2020 GDP numbers, China (+2.3% in the full year) has fared best among major economies but has been out-performed by both Taiwan  (+3%) and Vietnam (+2.9%), no doubt provoking mixed emotions. Some economies, notably Germany (only just) and the UK (after 3 negative quarters) will  record some growth in Q4 itself but, as shown in Figure 1, not enough to make up for the damage in previous quarters. With lockdowns being extended in many countries, the outlook for the current quarter is bleak. In fact, Figure 1 is as good a guide as any as to which economies are likely to get back to Q4 2019 GDP levels by the end of 2021  (Indonesia and South Korea as well as, not shown, Ireland, Norway, Poland, Lithuania, Malaysia, Morocco, Paraguay and Kazakhstan) while  the US might just make it depending on the size of the fiscal stimulus. Most should get there in 2022 but others may well not until 2023 or even later (Italy, Mexico, Japan and South Africa as well as, not shown, Spain, Greece, UAE, Brazil, Argentina and Nigeria). The Bank of England is much more optimistic than the IMF in expecting UK GDP to reach its Q4 2019 level as soon as Q1 of 2022, which looks ambitious to say the least. 

Unemployment numbers continue to be a concern everywhere but only the US is yet reporting consistently poor data. The January PMI Surveys, especially for Services, are signalling weakness in Japan, the Euro Area (less so in Germany) and the UK but remarkable robustness in the US.In contrast,actual Industrial Production is struggling in most economies (with the inevitable exception of China) while Retail Sales have started to flag in the US, UK and much of the Euro Area and appear to have hit a plateau in China. Perhaps a further sign of pandemic fatigue is the slide in Consumer Confidence in the US, Euro Area (including Germany) and the UK.

Figure 2 Lifting COVID-19 restrictions may boost inflation in the short term

Despite the bad news on growth there is much talk in the US of inflation, which is pushing up the price of Treasury Inflation-Protected Securities (TIPS) because of higher break-even levels with standard USTs of the same maturity, with yields on the latter in turn being pulled higher. The proposition is that the ultra-loose monetary policies that have been boosting asset prices for the last 12 years will switch to pushing up consumer prices. More immediately, the lifting of pandemic  restrictions would send consumers out spending the money they have been saving while stuck at home, thereby sparking demand-pull inflation. Meanwhile, demand would be fuelled even more by the huge fiscal stimulus packages (Figure 2). All this would occur at the same time as cosh-push inflation, caused by the pandemic restrictions’ disrupting supply chains and pushing up raw materials and labour costs. 

Figure 2 provides some support for the inflation proposition, based on research from the Federal Reserve Bank of San Francisco that distinguishes breaks down consumer expenditure items (excluding food and energy) that saw significant price moves in the early months of the pandemic (a long list) and those that did not (a shorter list but notably including housing, financial services and, perhaps surprisingly, cable TV, internet and video games). The latter account for ‘Covid-Insensitive Inflation’, which has been falling steadily since long before the pandemic and could well experience a short-term reversal due to rising costs. However, any splashing out on holidays, eating out, sports and other entertainments may soon settle down and some people will be neither willing nor feel able to join in. There is also little historical evidence of public spending generating inflation directly. A further and more technical argument that corporations as well as individuals will be inclined, as the pandemic recedes, to repay much of the debt they had taken on to tide them through the crisis, thereby reducing the supply of money that the Fed has been so assiduously printing. 

Although the core PCE Inflation Index in the US has been consistently running well below the Fed’s 2% target, it should be noted that Japan, Malaysia, Thailand and Singapore have been experiencing deflation for the last several months while inflation is running at less than 1% in China,Euro Area, South Korea, UK Canada and Australia. It is, of course, the case that the price indices fell steeply several months ago in many of these countries (in the US too) and that there will some sharp increases by the early summer. On balance, however, it seems that the pandemic will last enough to inflict serious damage on consumer and businessconfidence in most economies, thereby limiting any inflationary spikes.

Figure 3 The pandemic requires new priorities

One does not need to be particularly cynical to believe that the key question for many investors is not whether inflation takes off or not but rather what if anything the central banks may or may not do. Public statements consistently show the major central banks to be more concerned about recession and Unemployment and, in any case, not expecting much inflation. Intriguingly, however, there are hints that some bankers (not including the Bank of England, it seems) are losing confidence in the efficacy of QE programmes and ultra-low interest rates in generating GDP growth and are becoming increasingly uncomfortable that equity markets  are hooked on such policies in order to justify pushing share prices to ever more unsustainable levels. Somewhat poignantly, the pandemic could provide the cover for a change in tack. Unprecedented fiscal stimuluses, with a lot more to come, are creating a funding challenge that will far exceed the current QE asset purchase programmes. Figure 3 shows that the Bank of England has already been doing its bit (with more to come) to support the UK Government’s emergency spending, even though all concerned officially deny it. The Fed has been doing the same although its much larger purchases make it less obvious… for now. One does not need to subscribe to Modern Monetary Theory to believe that it would be a lot easier if the central banks simply gave governments overdrafts rather than go through the rigmarole of public debt auctions and market operations. To do this would, of course, undermine the orthodox monetary policy that has prevailed for decades and unleash warnings of ‘Weimar Republic’ hyperinflation. We can expect much debate in the coming months as to how public deficits should be funded and the inflation hawks will be in full cry. A change in central bank priorities does not mean that interest hikes are imminent but it would make it much easier to impose them down the road. Many economists but rather fewer investors really do seem to expect inflation but even if they are wrong TIPS looks like a rather handy insurance policy.