Before the coronavirus crisis, an upsurge in inflation appeared an increasingly remote threat. Now it looks even less menacing as output has collapsed in the wake of the pandemic. But the immediate impact of an economic shock does not necessarily tell the full story. Further ahead, inflation could arise from its deathbed and punish investors who have come to take its quiescence for granted.
As economies continue to struggle in the wake of the shutdown, the short-term outlook is for even lower inflation. In June, the OECD forecast that by the final quarter of 2020 the annual rate will be just 0.2 per cent in Britain and zero in the eurozone. If there is a second wave of the pandemic later this year, inflation could become deflation.
But looking beyond the next year or so, there is a distinct risk that inflation could stage a comeback. One of the main forces bearing down on prices since the mid-1990s has been globalisation. As more and more products have poured in from low-wage Asian economies, above all China, it has been cheaper to buy goods and harder for western workers to push up pay. But that disinflationary tide of globalisation has been ebbing. The pandemic will intensify that trend as both businesses and governments heed security considerations and restructure supply chains.
Businesses are also likely to regain some of the pricing power they have lacked in the era of “lowflation.” The severity of the downturn will sweep away many of the zombie companies that low interest rates have (just about) kept alive since the financial crisis. That should make it easier for the firms that do survive to push up prices.
What’s more, expectations of price stability among consumers have been jolted. While the headline overall inflation rate sank to 0.5 per cent in May, research in June from the Institute for Fiscal Studies looked at everyday purchases of food, drink and household goods and found “an unprecedented spike in inflation at the beginning of lockdown.” The authors warned of “a possible return to stagflation”—the baleful mix of inflation and sluggish growth that characterised the 1970s.
Last but not least, there is little appetite to tackle big budget deficits and soaring public debt through renewed austerity. That will increase the temptation for governments to inflate it away. Increasingly compliant central banks could connive in this by arguing that an overshoot of their inflation targets would make up for the previous undershoot.
If inflation does flare up again it will spell trouble for conventional government bonds, which provide no compensation for rising prices. Once investors and traders expect higher inflation they will value such bonds less. By contrast, index-linked bonds, which do provide protection against inflation, will have their day in the sun.
In principle, equities should be less vulnerable than conventional bonds because they are claims on the real economy, specifically corporate profits, which should rise with inflation. But even they are unlikely to do as well as before, because investors become more cautious about the value they put on future earnings when inflation is on the march. Both bonds and equities suffered when the post-war inflationary tide swept all before it during the 1970s. They have done much better in the subsequent era of falling inflation.
A resurgence in inflation may seem unlikely now, but so, too, did the retreat that started in the 1980s. If inflation does return, markets will become less friendly places for investors, who will have to follow new rules to keep afloat.
