Rumors have it that the corona crisis heralds the return of ‘The Great Inflation’. Indeed, some fear that inflation will increase significantly once the containment measures are eased. This reasoning is partly based on the expectation that demand will quickly bounce back (pent-up demand) against the background of seriously disrupted supply chains. Others point out that both governments and central banks are experiencing an unprecedented expansion of their policies. This will supposedly result in inflation quickly overshooting the central bank target (in most developed countries about 2%).
Demand and supply
We are not convinced by these arguments, certainly not in the short term. The first reason is that the global economic activity will stay below potential for a considerable time. The gradual nature of the exit strategy in combination with high levels of unemployment and ongoing reluctance of households and firms to invest, will likely suppress economic activity in the years ahead. Indeed, the recovery process is likely to be long and complex. Across all industries, demand will lag behind supply. The supply side will probably see a relatively quick recovery once containment measures are lifted. And, unlike in a post-war situation, the infrastructure and labour force are more or less fully intact. This is not an environment that fosters rapid price increases, quite the opposite.
Obviously, this is not always the case. Higher demand or supply chain disruption may well lead to higher prices. The example of the food industry is a case in point. Grain and rice prices saw a sharp rise at the end of March due to increased demand from consumers (stock-piling) and governments (strategic stock replenishment), while exporting countries implemented export restrictions. Moreover, certain industries are confronted with logistic problems due to staff shortages. Finally, companies are facing extra costs to protect their staff and customers against the spread of the virus.
QE and inflation
In other words, inflation is not the main concern at the moment. In most countries, the rise in unemployment results in loss of purchasing power. And ongoing uncertainty results in higher risk aversion. Disinflationary forces will have the upper hand in the near term due to weak demand for goods, services and investments. Many regions and countries are reporting negative inflation figures at the moment following the collapse of gas, oil and industrial metal prices, To be clear, inflation is about the change in the price level and not about the actual price level itself, which means that the effect will be temporary. Therefore, it should not be confused with outright deflation.
So, how about the large-scale measures of governments and central banks? Well, it’s probably better to talk about support measures rather than stimulus measures. They aim both to mitigate the income loss suffered by households and firms and to safeguard financial stability and access to commercial bank loans As far as the quantitative easing programs (in brief QE) are concerned, it is essential to make a distinction between the money base on the one hand and the money supply on the other.
When the central bank buys financial assets (mostly government or corporate debt securities), its aggregate balance sheet and thus the money base increases. But the total supply of money does not increase at the same rate. The latter is predominantly a function of the bank loans to households and companies. And when economic prospects are weak, demand for loans will be weak as well. The liquidity injections of central banks will only lead to upward inflation pressure when the economy has returned to full capacity and the money effectively ends up in the economy via new commercial bank loans.
Policymakers realize that the risk of deflation in the short term exceeds the risk of inflation. And that’s precisely why inflation figures could yet surprise on the upside further down the road. Indeed, central banks will do their utmost to revive the extremely weak inflation prospects in order to create more room for manoeuvre in terms of policy response. This relates to the strong rise of public debt levels, as higher inflation would help in lowering the actual debt burden. Both monetary and budgetary policymakers jump at the chance to leave behind the last decade of uncomfortably low inflation.
‘Where there’s is a will, there is a way’, so the saying goes. Yet, this is easier said than done. Firstly, the past decades show that higher inflation figures do not just show up on command - as shown by experiences in Japan at the turn of the century and in the eurozone after the euro crisis. Secondly, there is a risk that the credibility of government institutions could be undermined if the general public were to perceive that upward price pressures are not met with more restrictive policies. Indeed, history teaches that inflation expectations can derail and cause major economic damage as a result.
In the medium to long term two other trends could contribute to upward inflation risks, namely the ageing of the population and the risk of deglobalization. In the first case, the rationale is that the potential workforce will become smaller compared to the popuation in retirement, so that the labor market will become increasingly tight and average wage levels will go up. As regards the second, some observers think that risk considerations will lead to a more regional production of goods and services. This leads to the end of the ever-continuing search for maximum-efficiency supply chains, as has been the case since the start of the nineties.
We made a conscious decision not to discuss these two phenomena here. The reason for this is that such a discussion would be largely outside of the scope of the corona crisis, but also that there is absolutely no consensus about this (yet) amongst economists. Moreover, these trends must be set off against the probability that digitalization and increased automation of production will result in a downward price pressures.
The upshot is that the chance of a quick and sharp rise in inflation is quite small. The key reason for this is the expectation that economic activity will remain below the potential output level for quite some time. The more distant is of course more uncertain. Inflation may well surprise on the upside further down the road. After all, both budgetary and monetary policymakers are attracted by the benefit of somewhat higher inflation figures.