Focus
May 08, 2020 | 15:08
Will Inflation Flare or Flop?
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Will Inflation Flare or Flop? |
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“Some worry about how we’ll be able to ensure that the expansion of the (Bank of Canada’s) balance sheet doesn’t lead to runaway inflation as economic activity recovers. …I could never dismiss this worry out of hand. Others are worried that the current situation poses the opposite risk—deflation.” — Carolyn Wilkins, Bank of Canada Senior Deputy Governor, May 4, 2020. As economies begin to gradually reopen, and markets struggle to gauge the shape of the near-term recovery, the longer-term impact of this traumatic episode is also a big source of debate. After concerns about the fiscal legacy of the massive income support measures, the next biggest anxiety among investors is around the potential for inflation to emerge, in part as a result of the huge budget deficits and related central bank bond buying. It may seem passing strange to even be talking about inflation risks, just weeks after oil prices went negative and after decades of stability in inflation trends (Chart 1). And, there is little debate that the initial impact of the global economic downturn in 2020 is disinflationary due to the steep drop in demand for a huge range of goods and services. The most dramatic example of this can be seen from the 1930s, when the Great Depression ushered in a full decade of outright deflation and Canada’s CPI fell at nearly a 2% annual rate (Chart 2). However, the longer-term history also clearly reveals that inflation can quickly morph from years or even decades of relative stability to a world of high and volatile trends following major shifts in the underlying economy. Inflation shot higher after WWII amid massive budget deficits, as one example. |
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Could this prove to be one of those key inflection points for inflation? Below, we consider the arguments for and against: The Case for Continued Low (or even Lower) InflationThe crux of the high-inflation case is that unparalleled government borrowing (outside of a war) and central bank asset buying are ramping up the money supply—U.S. M2 is now growing the fastest on record. However, as after the Great Recession, the burst of new money is unlikely to pump prices. The link between the money supply and inflation was likely severed by the 1990s when central banks began formally targeting inflation to better anchor expectations (Chart 3). Over the next decade, rapid globalization, fierce competition from China, and growing ecommerce also put a heavy lid on inflation. A larger money supply can’t lift inflation unless people use it to buy things, causing the economy to overheat. However, the recent acceleration is mirrored by an equally sharp decline in the turnover of money. Consumers and businesses are largely constrained from spending, which is why U.S. GDP is expected to collapse by 12% y/y in the current quarter. |
The Fed’s portfolio of assets has jumped nearly $2 trillion in the past two months and could top $10 trillion this cycle, more than twice the size post-Great Recession. To buy assets, the Fed electronically boosts the reserves of banks and other lenders from which it buys securities. However, if the reserves are not used to make new loans, demand stays restrained. That, in part, explains why there was little relation between the Fed’s balance sheet and inflation expectations after the Great Recession (Chart 4). Despite the Fed’s more aggressive journey into the QE waters this time, investors still expect inflation to average just 1.5% in the latter half of the decade. Most of the “stimulus” will simply offset the massive loss of income caused by the shutdowns, rather than stoke demand. As long as the fiscal support does not persist when the economy returns to pre-virus levels, inflation should stay in check. Longer term, measures to contain government debt will slow the economy and dampen inflation (think Japan since 1990). In the year ahead, COVID-19 will reduce inflation by: 1) Creating one big output gap. With real GDP expected to shrink at least 5% this year in the U.S. and Canada, the economy could operate below capacity for several years. Moreover, it could take even longer before the unemployment rate declines sufficiently—presumably to below 4% in the U.S. and 6% in Canada—to give workers the upper hand in wage talks. In fact, compensation was well behaved even before the crisis when jobless rates were near half-century lows. Price competition will remain fierce as many businesses will struggle to survive. Although demand will grow when the lockdowns end, supply will likely keep one step ahead. Prices for some items, such as meat, that are currently facing shortages, could keep rising for a while, but most goods and services will see downward pressure. |
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2) Hammering commodity prices. By shutting down large swathes of the global economy, the virus has put a giant vice-grip on resource demand and prices (Chart 5). A recent dip into negative territory for oil was just the most glaring example. However, apart from gold, all major commodities have fallen sharply this year. They are unlikely to snap back until global demand presses against capacity limits, which could take years. |
3) Turning consumers cautious. The pandemic could lead to a higher savings rate as fears of another outbreak linger until a vaccine is found. After the initial unleashing of pent-up demand, a more price-conscious consumer could emerge. People will still buy things they need, but perhaps think twice about discretionary items. According to a Nanos Research poll, over one-third of Canadians say their discretionary spending will be less than pre-virus levels even after stores reopen, while only 5% report they will spend more [1]. Commuting expenses could fall to zero for those working remotely, freeing up more savings. Deep scars from the pandemic could depress demand and inflation, which were both already under pressure from an aging population. Millennials, now facing their second economic crisis in just over a decade, might be more inclined to save. 4) Accelerating the shift toward ecommerce, telework and automation. Even if a vaccine is found, shoppers and businesses are unlikely to return fully to the old way of doing things. Some people who never considered buying items such as groceries online have become converts. Depending on productivity, more companies will shift toward remote working, passing savings from reduced office space to consumers. As well, more robots and automation will be required to assist social distancing in the workplace, which will only aggravate worker anxiety, keeping wages in check. 5) Boosting the U.S. dollar. After leaping more than 7% y/y in April, the broad trade-weighted dollar is at its highest level since at least 1970 (Chart 6), while the real exchange rate is at a two-decade high. Like consumers, investors could turn more risk averse even after the pandemic subsides, preferring to hold greenbacks and other safe-haven assets. A strong dollar will tamp down on U.S. import costs, assuming no escalation in the trade war with China. |
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The Case for Higher InflationThis case is pretty straightforward: inflation could become unhinged by the flood of government borrowing and central bank funding of public sector deficits. While quantitative easing had no discernable impact on inflation in the past decade, such policies have become even more aggressive and widespread today. For example, the Bank of Canada, a new convert to QE, has tripled the size of its balance sheet in a matter of weeks. Even the Fed is plowing into assets it didn’t dream of buying in 2008. And, the deeper and longer the downturn lasts, the larger and more persistent both the budget deficits and QE. One of the main arguments the BoC makes for downplaying inflation risks from QE is that many of its holdings will naturally roll off in the next year, and the Bank could even sell assets if the need arises. But, what if the downturn drags on longer than expected; or, worse, we are hit with a second serious wave later this year that requires another big slug of fiscal support? This would lead to an even bigger expansion of central bank balance sheets that lasts even longer. In such an extreme economic outcome, the tail risks for inflation would increase markedly as well. Another argument the BoC makes is, effectively, that it knows how to deal with high inflation (but deflation is a much harder nut to crack). True, but the solution is a significant tightening of policy, or higher interest rates. However, it is fair to wonder aloud to what extent the Bank would be comfortable cranking interest rates to control inflation if the economy is still struggling, especially given the pronounced build-up in debt levels by governments, businesses and households during the pandemic. On top of concerns about central bank balance sheets, a more fundamental inflation risk relates to the very real possibility of turning back the clock on globalization as a result of the pandemic. Insofar as companies re-shore production and reconfigure supply chains to reduce dependence on foreign suppliers, whether by choice or mandate, the net result will be added costs. Moreover, some industries could face additional cost pressures as a result of the pandemic. Increased cleaning regiments, greater distancing measures, and reduced capacity limits (think airplanes, restaurants) could be costly, pressuring inflation if consumers are willing to pay more. Such cost increases could accelerate consolidation in some of the affected sectors, giving more pricing power to the companies that prevail. Overall, Canada may be at a greater risk than the U.S. of a temporary burst of inflation. The Fed has plenty of experience with QE, while the BoC has none. As well, there is fundamental demand for the U.S. dollar which simply does not exist for the Canadian dollar; a significant weakening in the currency could trigger at least a short-lived bout of inflation in Canada. Having said that, we would return attention to Chart 1, which clearly shows that there has been precious little sustained separation over the many decades between Canada and the U.S. on the inflation front. The average inflation rate for both has been almost precisely 3% in the past 90 years. Portfolio ProtectionHow would an investor protect a portfolio against the risk of higher medium-term inflation? Real return bonds and gold should fare well in a higher-inflation world, which helps explains the latter’s solid run in recent weeks (Chart 7). Even if the inflation outbreak is largely confined to smaller economies, gold would have the added benefit of a quasi-currency hedge (note that it is now at record highs in C$-terms). Life-insurance companies and pension funds would benefit from higher interest rates, while real estate would suffer. Nominal bonds are the biggest potential loser from a significant resurgence of inflation. But note also that, adjusted for inflation, equities struggled heavily during the upswing in inflation from the early 1970s to the early 1980s. For example, the worst 12-month post-war performance by the S&P 500 in real terms was in the year to October 1974; that almost exactly coincided with an initial burst of double-digit inflation due to the oil-price shock, though a nasty recession also weighed. |
On the other side, the playbook is not exactly the opposite in a world of potential deflation, but it's close. The clear winner would be nominal government bonds, while commodities would likely struggle. Given the opposite of pricing power, and prolonged weak growth, equities would be challenged (see Japan's sideways stock market experience with deflation over the past three decades). Deflation would pose an extra challenge for indebted households and some high-priced housing markets. Investment options are mostly unappetizing to say the least amid deflation—there's a very good reason why policymakers strive to avoid it at almost any cost. The Verdict: We believe that the end result of this deep downturn will, in fact, be even milder inflation than the low-inflation world that prevailed pre-virus. Financial markets are generally leaning this way too—implied U.S. inflation five years out has faded from 1.8% to 1.5%—although gold prices are also reflecting the rising tail risk of higher inflation. We expect core CPI rates in the U.S. and Canada to test 1% in the year ahead, while headline rates approach zero due to weak oil prices. And, if the economic outlook worsens, a temporary dip into deflation can’t be ruled out. |
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However, the key point of our discussion is that uncertainty around the inflation outlook has clearly ramped up. The risks for extreme events have risen as a result of the abrupt economic disruption from the virus and the associated unprecedented fiscal measures. In other words, if the risks of deflation and higher inflation were deemed remote prior to the virus, neither is completely remote now. |
Endnote:[1] https://www.bnnbloomberg.ca/more-than-a-third-of-canadians-fear-a-permanent-drop-in-spending-1.1431683 [^] |