Econosights: Inflation in the COVID-19 world

Introduction

Inflation in the advanced world has been persistently undershooting central bank inflation targets (of around 2%) for the majority of the past decade. Structural factors (technological improvements and globalisation) and cyclical trends (sub-trend GDP growth post Global Financial Crisis resulting in spare capacity) have been the main drivers keeping a lid on inflation. Before the outbreak of COVID 19, inflation was expected to remain subdued (sub 2% per annum) across the majority of advanced economies. COVID-19 exacerbates the problem of spare capacity. A collapse in demand and large discounts on some services means some countries will experience deflation (or price falls) in the short-term. However, once spare capacity is worked through, the enormous amount of government and central bank stimulus may prove to be inflationary. We outline our expectations for inflation in this Econosights.

Money supply and inflation 

The recent spike in the money supply across numerous advanced economies has led to concern about a potential break out in inflation. The money supply is a measure of the value of cash and cash like instruments (like current deposits at banks) circulating in the economy. Global money supply growth (in US, Europe, Japan, China and Australia) has risen by 14% over the past year (see chart below), with growth in the money supply much higher than in any other period in recent history. The surge in the money supply across the developed world has been driven by central bank quantiative easing programs (which creates additional money in the system) and generous government fiscal payments and wages building up in bank deposits as households have been unable (due to lockdowns) or reluctant (due to uncertainty) to spend.

Some economists are of the view that excess money supply growth (the difference in growth of money supply and GDP) is a sign of future inflation because the more money there is for each level of production, then the higher the rate of inflation. The chart below shows the relationship between inflation and excess money growth.

This chart shows that inflation and excess money growth haven’t necessarily moved in the same direction over the last 30 years. Prior surges in the money supply have not always led to an inflation breakout. And at extremes, inflation and excess money growth actually tend to move in opposite directions (i.e. when there is a big rise in the money supply, inflation tends to collapse and vice versa). This is because at the economic peaks and troughs when inflation reaches a cyclical high or low, monetary policy tends to be significantly adjusted by central banks which either tightens or loosens the money supply.

Central bank asset purchases have been a big driver of narrow money supply (notes and coins) growth over the past decade. Asset purchase programs are potentially inflationary for asset prices, but not necessarily for goods and services prices in the real economy (which is what consumer price inflation measures). This is evident in broad money supply growth (which includes notes, coins, savings and deposits) being lower compared to the narrow money supply. It is also clear in the collapse in the “money multiplier”. The money multiplier refers to the ratio of nominal GDP to the money supply) and tends to be a a better guide to show how money is used for domestic goods and services purchases, rather than just looking at money supply growth. Growth in money velocity tends to lead inflation (see the chart below).

Money velocity growth in the US has plunged recently because of the huge fall in nominal GDP growth and a big rise in money supply. The large fall in money velocity is in line with our view that inflation in the developled world will remain very low over the next year and that deflation will be prevalent in some countries (like Australia) due to large price falls for some goods and services in the June quarter (e.g. petrol prices, rents, utilities).

Ultimately, to increase the money velocity, there needs to be a substantial lift in nominal GDP. Nominal GDP growth will rise in the current half of this year but the level of activity will be well below its pre-COVID level for some time (see chart below).

It will take several years for most economies to recover the lost output from COVID-19. Many businesses will not be able to operate at their same level of pre coronavirus activity (e.g. travel-related businesses, restaurants and shopping centres) because of social distancing requirements and consumers not resuming “normal” activities (China is evidence of this with consumer spending still well below is pre-COVID levels despite a “V shaped” bounce in industrial production related indicators).

Government fiscal stimulus and inflation

Across the world the government fiscal response to COVID-19 has been significant (see chart below). In most countries, the level of government fiscal support (as a share of GDP) was last at these levels around the time of the Second World War. If fiscal and monetary stimulus continues to remain easy once economic growth has rebounded and spare capacity has been used up, there is a risk of infaltion breaking out.

The other upside risk for inflation is that the pandemic leads countries to become more inward focussed and and concentrate on propping up domestic supply chains. In other words the deflationary force of globalistion seen over the last 30 years may start to be reversed.

Inflation targets and central banks

The inflation misses across the advanced world over the past decade have led to the question about whether central bank inflation targets need to be changed. In the US and Europe, reviews into central bank targets are currently proceeding but major changes are unlikely. In the US some movement towards “average inflation targeting” is likely. This would mean allowing inflation to overshoot and undershoot the 2% target, as long as over the course of the business cycle inflation averaged 2% (which sounds a bit like Australia’s approach). This method would allow for periods of higher inflation, which has been missing over recent times. An outright change to the inflation target (up or down) across the major central banks is unlikely. Increasing the inflation target would just mean being further away from your goals and reducing the target could depress inflation expectations even more, potentially risking ongoing deflation.

Implications for investors

Despite the big rise in the money supply over recent months from central bank stimulus, inflation is unlikely to move significantly higher while there is spare capacity in the economy. This environment means low interest rates are going to continue which will also keep bond yields down. However, inflation could creep higher once the level of GDP fully recovers and spare capacity is used up in a few years time if monetary and fiscal stimulus still remains accommodative. Share markets tend to be negatively impacted by inflation when it means that central banks are tightening interest rates – but we are a long time away from this occurring.