‘There’s No Experience On Which To Base Our Forecasts’: After The Virus, Hyperinflation Or Deflationary Spiral?

Since the onset of the coronavirus crisis and the attendant roll out of various stimulus measures, both monetary and fiscal, not a week has passed by without someone, somewhere, suggesting that policymakers are flirting with a hyperinflationary outcome down the road.

In most cases, this kind of rhetoric can be summarily brushed aside, given that it often emanates from the usual suspects who aren’t taken seriously in the first place. “The question is will the Fed be able to admit its mistakes and reverse policy in time to prevent hyperinflation?”, a delirious Peter Schiff wondered last month, in a representative example.

But charlatans and their trademark quackery aside, there is a serious debate going on right now about COVID-19 and whether it will ultimately set the stage for the eventual return of inflation in advanced economies. I’ve discussed this at length in these pages, often using surging wholesale meat prices in the US as an example (more on this here).

The key thing to understand in the near-term, is that coronavirus is a demand shock the likes of which the vast majority of living humans have never witnessed, and is thus a deflationary supernova.

Nowhere is this more evident than in oil prices, which of course collapsed in spectacular fashion this year, as demand quite simply disappeared. Although the fundamental backdrop is beginning to improve, the IEA expects this to be the single worst year in history for the global oil market.

The starting point for the inflation versus deflation debate is the notion that stimulus, in its initial incarnation, is not actually “stimulus” – it is rescue funding to prevent acute cash flow problems from morphing into an insolvency crisis.

HSBC captures this in a new note discussing the outlook for inflation in the context of the virus.

“Simply put, there is no past experience on which to base our forecasts. Policymakers have never had to deal with such huge contraction in both demand and supply on this scale before and with such little confidence of how events will unfold”, the bank’s chief global economist Janet Henry writes.

“Yes, the biggest and fastest monetary and fiscal packages are in motion but this is not currently a traditional stimulus to ‘pump prime’, or raise aggregate demand, in the economy”, she goes on to say, noting that while “that may come later, for now social distancing prevents a wide range of economic activities from taking place so the goal of the income support and funding measures is to try to ensure mortgages are eventually repaid and many bankruptcies are avoided”.

That’s the first consideration, and if you don’t grasp that, you’ll have an extremely difficult time going much further. Yes, there may be cases where prices for certain goods (e.g., US beef) surge, but on the whole, aggregate demand has just suffered a body blow of truly historic proportions, and as Henry goes on to point out, the effects of that are going to linger even after lockdowns are lifted.

Not only are consumption habits likely to change, but savings habits will too. “Households are… planning to reduce borrowing and presumably save more”, Henry says.

That, she remarks, means that “despite the huge fiscal measures to support labour incomes, household spending is set to remain extremely weak over the coming months, not only due to the direct impact of lockdowns, which are beginning to ease, but through persistent precautionary savings”. (There will likely be some pent up demand unleashed once lockdowns are lifted, but that doesn’t change the fact that the shock associated with mass joblessness will mean would-be consumers think twice about discretionary purchases going forward.)

Beyond the near-term, the picture is less clear, though. Eventually, barring some kind of truly disastrous outcome, life will return to something that feels at least vaguely “normal”, which will entail a commensurately “normal” resumption of economic activity.

At that point, questions about COVID-19’s medium- to long-term inflationary effects may start to get more attention.

Leaving aside the monetary and fiscal impulse and the fact that the legacy of the crisis will be bloated central bank balance sheets, zero/negative rates, and huge deficits, it’s entirely possible that a de-globalization push will ensue.

Among the many lessons from the pandemic, the world has learned that stagnating middle class incomes in advanced nations aren’t the only drawback to globalization. Increasingly interdependent economies, far flung supply chains, just-in-time management and interconnected financial markets mean that when one country sneezes, the rest of the world catches cold – or, in this case, catches deadly viral pneumonia.

That is a lesson that will not soon be forgotten. Unfortunately, political opportunists with questionable motives will invariably cite this episode as a poignant example of why hyper-globalization is undesirable. Peter Navarro, for example, has already done just that.

This is a highly unfortunate state of affairs. As I never tire of reminding readers, if you can abstract yourself from the context of developed nations and somehow observe things impartially from a utilitarian perspective (admittedly, adopting the “impartial observer” role is not easy), globalization is unquestionably a positive dynamic on net. It has, among other things, lifted millions out of abject poverty in developing nations.

Another thing globalization has accomplished is driving down consumer prices. That is now at risk. HSBC’s Henry summarizes as follows:

Once the global pandemic is contained, there will be some lasting consequences particularly for certain sectors and products in terms of re-shoring of some production or restricting exports. Most notably this would be in areas of healthcare, especially medicines and key hospital equipment and technologies. There will also likely be shifts in supply chains for other products to a broader range of providers now that the dangers of concentrating sourcing components in just one or two countries has become more apparent.

There could also be a more lasting impact on FDI and migration flows as well as investment more broadly. Screening of FDI (CFIUS) was already a feature of the US actions against China but the EU has also scheduled to implement a screening mechanism for FDI, aimed at deterring foreign companies from acquiring companies that threaten security and public order, including critical health infrastructure and inputs.

But Henry notes that a rise in goods prices could be offset by falling prices in the services sector, where, previously, providers enjoyed pricing power due in part to consistently lower prices for durable goods.

If goods prices rise, it will mean less for consumers to spend on services, and less demand will translate to lower prices, providing an offset. “That is exactly what happened through much of the 2010-2012 period and it took such services some time to recover their pricing power in the following year or two as goods price deflation resumed”, Henry goes on to say.

(HSBC)

But what about wage growth? Is that an avenue whereby inflation could accelerate? In short, probably not, because labor market slack will linger even if a large portion of recent job losses do, in fact, prove “temporary“.

“We risk a lot of small businesses having to close permanently, leaving the unemployment rate elevated for an extended period of time”, Barclays’ Michael Gapen cautioned on Thursday. A deflationary spiral is not the bank’s base case, but in remarks to Bloomberg, Gapen warned that  “if businesses close and there’s no one there to turn lights on as states re-open, labor market slack can get baked into lower inflation and inflation expectations”.

That is precisely what Goldman wrote early last week in explaining why the bank isn’t particularly concerned about inflationary outcomes despite the ostensibly combustible policy mix.

“As the global economy recovers, we are likely to hear louder voices warning that a failure to normalize monetary and fiscal policy risks much higher inflation or even currency debasement, so it is probably worth noting preemptively that we do not share these concerns”, Jan Hatzius wrote, in a May 4 note.

He went on to remind you that “much of the unprecedented easing of fiscal policy is effectively bridge financing that will automatically unwind when it is no longer needed [and] even under a reasonably optimistic growth forecast, it will take several years to put people back to work and fill empty offices and storefronts”.

(Goldman)

HSBC’s Henry echoes much of that in her own assessment.

She says that while the bank’s estimates do include a “fairly optimistic” rebound in growth next year, activity will still be lower by the end of 2021 than it was at end-2019.

“Such a degree of labour market slack is not a backdrop conducive to an economy-wide pick-up in wage growth [as] that would require a big acceleration in productivity growth and a willingness of cash-strapped companies to pass on the benefits to workers”, Henry remarks.

(HSBC)

It’s possible, she admits, that governments may move to mandate higher pay in the wake of the crisis. That push was already well underway prior to the pandemic in the US, and besides, wages for lower-paid workers were rising on their own.

But there’s a problem there too – namely that job losses are concentrated in industries where lower-paid workers predominate and because those industries are expected to be forever altered by the crisis, at least some of those jobs may never come back.

And let us not forget the structural factors weighing on inflation that have not been altered by the crisis. One example is automation.

While automating a business requires investment (and investment spending is expected to plummet with overall cash usage in 2020), it could be seen as a highly desirable use of scarce cash in the years ahead. After all, you can raise productivity with robots without having to pay them more, and there is no chance of a robot suing you for catching COVID-19 on the job.

“Higher productivity would mean higher potential growth and a higher neutral rate (r*) but would not necessarily be associated with higher inflation”, HSBC’s Henry reminds you.

Ultimately, her view is that due to the factors mentioned above (and several others she discusses in the full note), an across-the-board rise in inflation once the initial deflationary wave and subsequent bounce-back have run their course, is unlikely.

There are two potential tail risks, one inflationary and one deflationary. Here’s Henry:

1. If policymakers underestimate the permanent damage to supply from the pandemic and stimulate aggregate demand too much then inflation would follow. There is even a risk that higher inflation unfolds as part of a concerted determination by governments to inflate away the even larger public debt stock by running persistently loose fiscal policy backed by less independent central banks.
2. But if the permanent loss to supply proves to be minimal and yet the level of consumer spending remains materially lower, then the extra slack in the economy from a failure to stimulate demand sufficiently could result in below-target inflation or even outright deflation.

Whichever side of the debate you fall on, you can find something to agree with in one of those two points.

Below are the basic questions that need to be asked, even if we cannot, by virtue of how indeterminate things are, answer them at present. From HSBC:

• But what happens when the level of demand returns to a new normal, whatever that may be?
• Will the supply shocks (including de-globalisation trends) persist beyond the economic contraction and combine with the unprecedented monetary and fiscal stimulus to prompt a resurgence of inflation?
• Or will we be back in the pre-pandemic era of structurally low inflation across much of the world?
• In particular will the technological advance and lack of labour pricing power mean that the rise in CPI fails to gain traction, meaning that any bigger inflation is purely restricted to asset prices?
• Or will policy makers try to – or be forced to – reverse the stimulus prematurely with the result that demand quickly falters and sends us into deflation and widespread defaults?

It’s all food for thought as the world looks ahead to an (extremely) uncertain future.

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