Five forces that could drive the return of inflation

July 01 2020

Giles GaleHead of European Rates Strategy

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Has coronavirus laid the foundations for a rise in inflation? We think so, in the medium-term at least. In this article Giles Gale outlines the reasons why.  

A decade ago, investors took inflation risk seriously but in recent years it has faded to a background issue. In the wake of the coronavirus crisis, could inflation now be set for a return though?

As we outlined recently in our take on the economic recovery, probably not in the short-term. However, it’s looking a lot more likely in the medium term. Let’s take a look at some of the potential drivers. 

1. The sheer scale of recent fiscal responses

The stimulus measures from governments and central banks during the global financial crisis (GFC) didn’t result in inflation, so why could this time be different?

Firstly, the scale of government responses will result in larger government deficits than the GFC, and it is being funded directly by central banks at an unprecedented pace, as can be seen in the chart below, particularly in the US and Japan, but also in European countries such as Germany, Italy and France.

Fiscal stimulus is greater than in 2009

Source: IMF

Secondly, furlough schemes essentially mean money is being printed and going straight in people’s back pockets in return for no output. With this money in hand, there’s clearly going to be a higher propensity to consume than seen through, say, tax rebates. This direct support for demand will support inflationary pressures.

2. Rising costs of goods and services

Firms have been offered loans, not grants, to help them stay afloat. While credit is cheap at the moment, it piles up, so they’re unlikely to want to take on too much debt.

Firms may try to keep their prices high in order to survive as it doesn’t seem like the right time for the average firm to absorb cost shocks to preserve market share. In fact, we’ve been here before: in 2008, liquidity-starved firms raised prices.

What’s more, supply will be severely constrained in some industries, and capacity slow to recover. Enforcing social distancing measures will impose new costs and capacity constraints on many firms in the service industries, most notably those in hospitality. All this is likely to lead to higher prices.

3. The de-globalisation of supply chains

China’s share of world trade has stagnated since 2016. While comparative manufacturing advantages such as network or scale remain, rising local wages are eroding some of the original cost benefits of sourcing from China. The same trend can be seen in Eastern Europe.

Supply chain management could also have a very different focus in the coming years with efficiency becoming secondary to resilience and “security”.  US-China trade relations have not improved during the coronavirus crisis (see our article on this topic here) and national security has become an even stronger reason to reshape trade patterns. Meanwhile, in the EU there are intentions to reduce reliance on foreign suppliers. Firms globally will also be reviewing supply chains with diversification potentially as or more important than pure cost efficiency.

This potential for supply chains to de-globalise could lead to price rises. 

4. The migration slowdown

Political nationalism and better wages in countries that have traditionally exported labour have led to a slow-down in migration. Researchers are often cautious about the impact of migration on inflation, and in particular wages. However, even if migration has a limited impact on wages, additional labour is likely to improve efficiency and enable firms to expand in some areas. Slower inward migration might well be expected, all else being equal, to lead to a rise in inflation.

The foreign-born population in the US has stopped increasing in recent years

Source: FRED

5. The inflationary influence of aging populations

The global population is getting older, on average. Sometimes it’s assumed that the influence of this trend is disinflationary, because people consume less as they age. However this is not generally true: people don’t stop consuming entirely during retirement and, if we take into account healthcare costs, consumption in retirement years may actually increase.

Additionally, these generations stop producing any output typically measured in traditional economic terms.

 Login into Agile Markets for full analysis and for other insights on the post-coronavirus future visit our Decade Ahead series.

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