Inflation in a post-coronavirus world

Key points:

• In the aftermath of the COVID-19 pandemic, weaker growth may see prices fall
• Debt creation to deal with this crisis will be on a par with wars
• Pandemics have a record ofr sparking above-inflation wage rises, exerting upward pressure on prices
• Gold, infrastructure, inflation-linked bonds and real estate have tended to provide protection against inflation.

The coronavirus pandemic has caused growth to plunge. A resulting recession should have a deflationary effect on the global economy. Weaker activity, along with excess production capacity, usually causes prices to slow, if not fall. This time, significantly weaker commodity prices will lower headline inflation.

Since the pandemic struck, central banks have eased policy, starting programmes to pump liquidity into the economy. Indeed, the US Federal Reserve’s balance sheet has expanded by $2.3tn in six weeks. Governments have also reacted, with fiscal measures mostly aimed at supporting demand. This is happening when most companies have reduced activity. Some have stopped it altogether. In addition, in such uncertain times, many households are likely to save more and consume less.

In the last three decades the trend to globalisation has contributed to lower inflation rates by allowing companies to reduce employment expenses or create more efficient supply chains. Any reversal of the globalisation process is likely to raise business costs. A sustained period of social distancing could also make it more expensive to run a consumer-focused business, as the number of consumers able to use premises safely is cut. In addition, wage rises might run ahead of inflation after the pandemic. Research by the Federal Reserve Bank of San Francisco found examples of this in many previous pandemics.

Mounting debt burden

Debt creation to deal with this crisis will be on a par with wars. But, dealing with the stock of debt is likely to be different. Growth usually surges following a war, as investment is needed to replenish destroyed capital. However, recovery from a pandemic does not usually see such a response. While a fast growing economy helped to cut the debt burden after World War II, growth is unlikely to be strong enough to meaningfully reduce government debt this time.

Debt as a share of output in most developed countries may top that seen during periods of war, given the amount of debt that global authorities are creating in response to the pandemic. As such, central banks might turn a blind eye to inflation so it eats into the nominal debt level.

The outlook for inflation looks different depending on whether being guided by equity or fixed income markets. Equities have rebounded since the sizeable falls seen in early March, hinting at a quick, strong pickup in the economy once the effects of COVID-19 subside. At the same time, the US five-year, five-year forward inflation measure, which shows market expectations for inflation in a decade, hit an all-time low in March.

While it is difficult to predict inflation over anything but the very short term, there seems to be convincing arguments in favour of adding marginal protection against inflation to a portfolio. Inflation-linked bonds, gold, infrastructure and real estate are among asset classes that have typically provided the best hedge against inflation.

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