Charting the Potential Course of Inflation

What will happen to inflation? This is one of the most important economic issues as we emerge from this crisis.

Even on the eve of this crisis, inflation was low. At the time of its spring meetings, in April, the International Monetary Fund noted that inflation was below target in two-thirds of inflation-targeting countries. The crisis has exacerbated these previous trends. Inflation pressures have eased.

In the UK, for instance, inflation decelerated, from an annual rate of 1.5% in March to 0.8% in April. Zero inflation is possible in the coming months. The Bank of England, in its May Monetary Report, foresaw consumer price inflation of 0.6% in 2020 and 0.5% in 2021 before returning to its 2% target by 2022.

Thus, the UK is in a low inflation environment. Domestic inflation pressures are subdued. Twice in the last decade the UK has witnessed an inflation shock, triggered by a much weaker pound leading to a rise in imported inflation. But with sterling already very competitive that is unlikely now. Also, external inflation pressures are subdued, with the UK sharing in a global trend.

We expect inflation to stay low

So far this year, inflation has fallen sharply across the globe. And, at one stage, as oil prices collapsed to below zero, deflation (a sustained fall in prices) became a fear. Although oil prices have recovered, they are still at low levels and deflation fears have not fully disappeared. Japan’s experience with deflation in recent decades helps explain why.

If the world economy were to weaken further deflation would become a genuine possibility, but this is not the most likely scenario. We expect economic recovery instead and latest indicators from across the globe are consistent with that.

There may be pent-up demand in some sectors, as people who have been unable to shop, start to spend. In contrast, the health and economic shock, plus the uncertainty impacting many sectors and jobs, could lead to a rise in precautionary savings. The picture is likely to be nuanced.

We expect a low inflation environment – in the UK and globally. Firms are likely to be under pressure to keep costs down, and may not have much pricing power. Wage growth, too, would likely be subdued.

Yet an inflation resurgence is possible

Just as deflation would be a worry, so too would be a resurgence of inflation, and that is perhaps a bigger risk. If inflation is not low it is more likely to be because prices are higher, rather than deflationary.

It is important to appreciate the significance of this inflation issue in terms of how it impacts the outlook for debt, including government borrowing. Deflation is not good for economies carrying high debt. In contrast, it is often said that inflation erodes the overhang of the debt, helping borrowers, but if inflation leads to higher interest rates and borrowing yields it can trigger increased debt servicing costs.

Low inflation leads to both low interest rates and bond yields. This does not mean that there is a magic money tree, instead low inflation, rates and yields allows the government the ability to sustain higher borrowing for longer. This means the government can avoid austerity or tax increases, either of which could derail or weaken the economic recovery.

In turn, to retain the confidence of the markets, the government could plan to reduce debt to GDP gradually, over time. Low inflation provides more room for manoeuvre in the near-term. When it comes to corporate debt, it does not, of course, remove the challenge facing many firms who may emerge from this crisis with high debt.

Low inflation implies not only that higher levels of debt are sustainable but the welfare cost of this for future generations is minimised. The implication for the UK and other governments is that they should be more relaxed about running deficits if this is needed to maintain output at a level close to its potential in the short term.

But where is the inflation risk?

To what extent will some of the structural features that contributed to low inflation change as a result of this crisis? For instance, wage growth in the UK and other western economies has been suppressed in recent decades by a combination of: less bargaining power for workers; technological change; and by globalisation, with the latter reflecting intense international competition.

Also, in the UK one could add to these the effect of a large increase in the labour supply because of immigration. And financialisation has also been seen as an influence, in the way firms have been driven to achieve financial results, supressing the share of wages.

Could we be at an inflation turning point? I was one of those early to the view that inflation was no longer a problem and that inflation was set to fall sharply at the start of the 1990s. Then the consensus was badly caught out. That showed how quickly the inflation dynamics could change. After such a prolonged period of low inflation, and with such a huge policy stimulus now, there is a need to be aware of the potential inflation risk emerging quickly.

There are four risks that could contribute to higher inflation that merit attention:

One, is if the crisis triggered deglobalisation, as this would reduce competitive pressures and possibly add to higher wage growth and costs. This crisis might lead to firms onshoring more production or adding more slack into supply chains. The focus may not just be on cost competitiveness but also on risk competitiveness, and the ability to cope with future shocks. However, as a service sector economy, many of these issues may not impact the UK directly.

Two, is if the crisis damaged the economy’s supply-side potential with firms going bust, in which case a post-crisis recovery in demand would trigger bottlenecks, push costs up and raise firms’ pricing power. The deceleration in the UK’s trend rate of growth in recent years has already raised questions among some policy makers about the potential speed limit of the economy, above which higher inflation would follow.

Three, would be the pressure from debt monetisation and stronger monetary growth; an area too often overlooked. If debt is sold to the non-banking sector then this worry does not exist. But the challenge here is if the central bank buys the debt directly from the government or through the market from the banking sector. The latter, for instance, creates an asset for the banks, the counterpart of which on the liabilities side of their balance sheet is an increase in deposits, leading to higher monetary growth. The fear is too rapid an acceleration in monetary growth may feed inflation.

Four, if as a result of these, inflation expectations rise, feeding upward pressure. Currently, financial markets imply inflation expectations remain low, in the UK and globally.

If one was to consider these four, it is possible to see some deglobalisation leading to higher wage growth, to see supply capacity being hit in some sectors and to see higher monetary growth, given the scale of the policy stimulus. Thus, the risk of inflation cannot be ruled out.

However, this is offset by a number of other factors. The current scale of the collapse in the economy; that there will be an output gap until the end of next year, dampening pricing power; and that even if the economy returns to pre-crisis levels by the end of 2021, closing this output gap, it may take longer for employment to recover fully, potentially dampening wage pressures.

All this is relevant for the level of yields and the ease with which the budget deficit and government debt can be serviced. In international capital markets, recent years have witnessed the growing importance of international factors in driving yields, with a convergence across many different countries.

So, for now, the focus is on the potential turning point in the UK and other economies. After the sharp and speedy collapse in activity, the bottom of the cycle will be reached in Q2. Then recovery can begin. When it does, expect more focus on the potential inflation pressures ahead.

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