Deflation, Inflation, and the Disappearance of Deficit Phobia

07 Apr, 2020

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Inflation is, essentially, the expression of excess demand or, on its flip side, a sign of depressed supply. The trillions of freshly ‘minted’ dollars and euros that seek to maintain an equilibrium of sorts between supply and demand whilst the corona pandemic throws economies into disarray, are for now unlikely to stoke the fires of inflation. Most economists agree that the vast sums being spent in an attempt to put a floor under sagging markets merely replace lost revenue and income. The idea behind the largesse displayed by central banks and governments is to keep the economy ‘in situ’ on life support, ready to be revived once the pandemic has abated.

Curiously, some economists fear that over the coming weeks and months, the spectre of deflation poses a more serious threat. Demand, they argue, has all but evaporated in a number of crucial sectors such as construction, retail, and travel and leisure. This places a downward pressure on prices. Cheap oil only reinforces this trend.

Chief Economist Joseph Lupton of JP Morgan Chase expects a ‘colossal’ deflationary shock and points out that the prices of key commodities such as oil and copper are heading south. He also notes that large chunks of the services sector are unable to attract business without offering sizeable discounts: “Falling prices – deflation – makes it harder for companies to honour their financial commitments. Some may survive by cutting back on investments and payrolls, others will face bankruptcy.”

Former Chairman Bill Dudley of the New York Federal Reserve Bank agrees but cautions that in the medium term the rescue packages may cause inflation to return. Mr Dudley argues that the price correction now taking place will prove to be of a passing nature. In this scenario, timing is of the essence: monies pumped into the economy must be removed before demand spirals out of control. Both short-term deflation and medium-term inflation are capable of prolonging the recession now taking shape. Hence, central banks need to rediscover their traditional role of ensuring price stability. They must do so without the benefit of classical monetary policy instruments such as signalling their intentions via interest rates. When rates hover close to zero, monetary policy is only meaningful as a tool to rein in a galloping economy. In the foreseeable future, no major economy seems likely to require such a brake on growth.

As the first numbers trickle in, deflation already appears to have taken hold in China where producer prices retreated by 0.4 percent in February. In the UK, the British Retail Consortium last Wednesday reported that high street prices dropped by an average of 0.8 percent in March. In the US, airline ticket prices fell by 14 percent in the second week of March whilst average revenues per hotel room plummeted by a staggering 80 percent in the closing days of last month.

Professor Charles Goodhart of the London School of Economics is not surprised or impressed by reports of deflation. He is, however, concerned on what follows once the corona virus has been successfully contained and the economy is revived: “The answer, as in the aftermath of wars, will be a surge in inflation, quite likely more than 5 percent and even in the order of 10 percent in 2021.”

Some economists would welcome such an elevated level of inflation as a clear sign that demand has been fully restored and business is booming. However, markets in Europe and the United States do not think a return of inflation likely. The US swap rate, indicative of inflationary expectation five years down the line, has only climbed to 1.49 percent – up from an all-time low of 1.09 percent two weeks ago. The 10-year ‘break-even’ rate derived from government bonds with a built-in price correction, crept up to a paltry 0.96 percent. In Europe, the swap rate actually dropped from 1.15 percent in early March to 0.72 percent this week even though the European Central Bank ditched all limits on bond purchases and injected another €750 billion into its asset-buying programme.

Though central banks and governments may have binned the rulebook, the performance of economies still depends on a mysterious mix of market sentiment and rationale. Murphy has a role to play, as do less fickle forces. Conventional logic dictates that a measure of pent-up demand, vast amounts of cheap credit, and the wishful thinking of diehard optimists cannot possibly fail to deliver economic buoyancy once the pandemic has receded. Quoted in the Financial Times, Chief Global Strategist David Kelly of JP Morgan Asset Management predicts an economic surge – a tsunami of sorts – on the back of the virus’ demise. He warns investors to keep an eye out for inflation and says that expectations are kept artificially low by investors abandoning illiquid instruments with build-in price correction: “A few years down the road there is a significant chance of more inflation.”

The impending conundrum gets slightly worse when factoring in the ultimate fate of the trillions now being created and disbursed – ballooning already bloated balance sheets of central banks and dipping both countries and businesses ever deeper in debt. Sooner or later, this money needs to be removed from the economy. Inflation may help with that, forcing central banks to jack up interest rates and governments to curtail spending.

That last bit may prove hard as deficit phobia was counted amongst the first victims of the pandemic. Even the most fiscally prudent governments swiftly removed nearly all spending constraints and are orchestrating bailouts on a scale unimaginable a few short weeks ago. Both Germany and The Netherlands, two notorious budget hawks, have vowed to protect vital sectors of their economy, even considering the nationalisation of iconic corporations. Dutch Finance Minister Wopke Hoekstra refused to rule out a takeover by the state of flag carrier KLM in order to preserve the gateway function of Schiphol Airport and the 150,000 or so jobs associated with it.

As such, the corona pandemic may well turn out to be the ultimate black swan event, changing the underlying fundamentals of economic policy. It may be a bitter pill for liberals to swallow, but once the distaste for state intervention has been overcome, it may prove difficult to return to the laissez faire ways of old.

The problem is, of course, that not all states are created equal and some may be better in handling the added responsibilities than others. In Europe, the strong opposition in the north to the mutualising of risk via Eurobonds originates in a deep-seated distrust of the ability of some Eurozone member states to manage state finances properly. Vastly expanding the role of the state in the management of the economy opens the door to a dangerous relaxation of basic governance and accountancy rules. Still, there is no reason, other than an ideological one, why a state cannot run an airline, or some other major corporate, profitably. If in doubt, or in need of real-life examples, please take a look at Ethiopian Airlines or, on the opposite end of the scale, Alitalia.