Inflation dilemma

Key points:

• The COVID-19 pandemic has hit economies and may trigger weaker price growth, if not deflation
• Any reversal of globalisation after the crisis would probably increase costs for most companies
• Wage rises have usually run ahead of inflation after pandemics, putting upward pressure on prices
• Inflation-linked bonds, gold, infrastructure and real estate have typically provided some protection against inflation.

The COVID-19 pandemic has caused a dramatic plunge in global growth. A resulting recession should have a deflationary effect on the global economy. Weaker activity, coupled with excess production capacity, usually causes prices to slow, if not fall. This time, the effect of much weaker commodity prices is also likely to depress headline inflation.

Central banks have reacted to the crisis by easing monetary policy and establishing initiatives to inject more liquidity into the economy. Not least the US Federal Reserve, whose balance sheet has risen by $2.3tn in six weeks. Governments have also done their bit, with fiscal measures passed that are mostly aimed at supporting demand, whether through loans, grants or social security benefits to individuals and businesses. This is happening when most companies have reduced, or stopped, their activity. Meanwhile, many households are likely to save more and consume less in such uncertain times.

Over the past 30 years, globalisation has helped cut inflation rates by enabling companies to cut employment costs or achieve more efficient supply chains. Any reversal of globalisation would probably increase costs for most companies. A long period of social distancing could also make it more expensive to run a consumer-focused business, as the number of consumers able to use premises is cut to ensure a safe distance is kept between them (restaurants, airlines and shopping malls are among businesses that are likely to face this issue).

Furthermore, wage rises may run ahead of inflation after the pandemic. Research by the Federal Reserve Bank of San Francisco found examples of this in many previous pandemics.

Pandemic recovery and the debt burden

This pandemic will be comparable to wars when it comes to debt creation but dealing with the stock of debt is going to be different. Growth is usually strong soon after a war, as much investment is needed to replenish destroyed capital. However, pandemic recovery does not usually call for such a response considering the output gap. While a strongly expanding economy helped to reduce the debt burden after World War II, growth is unlikely to be strong enough to meaningfully reduce government debt this time.

Given the amount of debt the global authorities are creating to support their economies, debt as a share of output in most developed countries may supersede that seen during periods of war. As such, central banks might turn a blind eye to inflation so it eats away at the nominal debt level.

Equity and fixed income markets are taking divergent views on inflation prospects. Equities have strongly rebounded since the sharp falls seen in early March, hinting at a quick, strong pickup in activity once the effects of COVID-19 dissipate. Meanwhile, the US five-year, five-year forward inflation measure, which reflects market expectations for inflation in a decade, hit a record low in March.

While it is difficult to forecast long-term inflation, there seems to be convincing reasons in favour of adding marginal protection against inflation to a portfolio. Inflation-linked bonds, gold, infrastructure and real estate are among asset classes that have typically provided the best hedge against inflation.

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