The COVID-19 pandemic has revived a familiar conversation about the inflation genie escaping the bottle. The speculation is similar to the one that surfaced in the immediate aftermath of the Global Financial Crisis and at various points since then: That we are likely to experience a burst of inflation in the coming years.
Cynical investors will dismiss this risk out of hand. We urge caution in dismissing it, particularly given the unusual – bordering on the unprecedented – nature of the coronavirus shock and the size of the policy response.
That said, our base case for the medium term is that the inflation problem we will face in the years to come will look a lot like the one of the recent past – namely, too little inflation.
However, we think that the probabilities of both much too little and too much inflation have both significantly increased, thanks to the pandemic.
The short term: Two atypical drivers
In the very short run, inflation is being driven by two idiosyncratic factors:
- The recent collapse (and even more recent partial recovery) in oil prices.
- Measurement problems: national statisticians are imputing prices for goods and services where no transactions are taking place.
We are interested in where inflation will be from the second half of 2021 onwards. By that time, these base effects should have washed out.
Rather than making bold claims, we believe it is better to explore the drivers of inflation and tease out the potential risks around the prevailing view among most investors: Inflation will not, and perhaps even cannot, return.
We believe these are the potential drivers of the much too weak and too strong inflation scenarios:
The output gap between demand and supply
- The downside risk here is that demand fails to recover, leading to a larger disinflationary impulse.
- On the upside, the risk is that there is significant and lasting damage to the supply side that causes the output gap to close faster than expected, leading to less disinflationary pressure than we might expect.
Costs (not reflecting the output gap)
- The obvious downside risk here is the potentially steep decline in occupancy costs as companies shift to a teleworking model. What is less clear is whether such an adjustment manifests itself in lower prices or higher profits in the short term.
- Higher minimum wages and minimum income guarantees represent an upside risk (now that oil prices have already recovered, the risks from energy prices are somewhat diminished). For individual open economies, large movements in the exchange rate can pose an upside or downside risk.
- The downside risks here are that constrained consumers become more discerning, leading to a compression in mark-ups. Or, that the pandemic prompts a shift in public policy that involves a more muscular approach to antitrust.
- On the upside, the risk is an increase in the pricing power of domestic companies that survive the pandemic thanks to a combination of rising defaults and reverse globalisation (re-shoring).
- The risks seem tilted to the upside, but are more modest in scale, with the probability of higher taxation of carbon for environmental purposes and the possibility of higher indirect taxes for fiscal consolidation and (in certain countries) higher tariffs for protectionist purposes boosting inflation.
- The obvious downside risk here is ‘Japanification’ – the persistent experience of too little inflation de-anchors expectations.
- On the upside, the risk is that the extreme central bank response shakes confidence in low and stable inflation.
For more on our views on inflation:
Or listen to our latest Market Weekly podcast, ‘Much too little inflation or too much inflation’