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Why Morgan Stanley Sees ‘The Return Of Inflation’ After Coronavirus Crisis

"The forces which will bring about inflation are aligning".

Everyone (or almost everyone, anyway) understands that COVID-19 is deflationary on net in the near- and medium-term.

Yes, there are pockets of inflation directly attributable to disruptions brought about by the virus. Grocery prices in the US – which surged the most in 46 years last month – are perhaps the most poignant example.

But broadly speaking, we are witnessing the largest demand shock in a century, and the deflationary impact of that has shown up dramatically in, for instance, oil, which briefly became worthless last month.


Core inflation in the US dropped the most on record in April, even as food at home prices surged alongside the cost of beef, which was driven inexorably higher by shutdowns at some of the country’s largest meatpacking facilities.

And yet, over the longer-run, there are a number of inflationary risks, including, but not limited to, supply chain issues, on-shoring, a reinvigorated protectionist push and, of course, unprecedented fiscal stimulus, which is being enabled by monetary policy to an extent not witnessed previously.

Read more: After The Virus, Hyperinflation Or Deflationary Spiral?

To be sure, coming down squarely in the inflation camp is a risky proposition. Suggesting inflation is about to take off, even on a lag, while most of the world is still grappling with the reality of mass job losses and unthinkable output contractions chances being laughed off stage.

But Morgan Stanley lays out a trenchant case for “the return of inflation” in a lengthy global economics piece out earlier this month.

After noting that “the consensus remains in the disinflation camp”, the bank’s chief economist Chetan Ahya contends that “this cycle will be different as a tectonic shift in policy is preparing the ground for renewed inflation”.

“Just as the disinflationary forces of the past 30 years were largely underestimated, we think that the consensus may now be overlooking the potential for renewed inflation”, he says, setting the stage.

When it comes to policy, Ahya says the seeds were sown for a shift before anyone knew anything about COVID-19. He cites widespread disaffection in advanced economies after years of ballooning wealth gaps. To wit:

Prior to the Great COVID-19 Recession (GCR) falling natural interest rates (hence monetary stimulus on its own has been inadequate) and the absence of active fiscal policy had weakened inflation expectations despite the lengthy expansion. The interplay of trade, tech and titans was already working in the background, dampening inflation dynamics but also contributing to the fall in wages’ share of GDP and the rise of income inequality. Discontent has risen, intensifying pressure on policy-makers to address these issues.

Crucially, Ahya blames the lack of fiscal assistance (i.e., the absence of a helping hand for monetary policy) in the post-financial crisis world for the inability of growth and inflation to pick up in a truly healthy way.

Indeed, there are plenty of examples of fiscal belt-tightening (i.e., austerity) working at cross purposes with monetary policy, leading to the patently absurd outcome of central banks cutting rates to zero (or below) and gorging themselves on assets, while politicians effectively short-circuited things. All the while, the “3 Ds” were at play. Here’s Ahya:

We have argued for some time that the developed economies were facing demand deficiency and consequently found themselves in a low-growth, low-inflation loop. Across DMs, weaker demographic trends, high debt levels and disinflationary pressures have become more prominent. We have also been arguing that active fiscal policy has a constructive role to play in breaking out of this environment. But fiscal expansion was largely absent post the GFC and, at times, policy-makers even undertook fiscal tightening which was working to counter the effects of monetary easing.

Monetary policy working in isolation can approximate a perpetual motion machine for inequality. This is a side effect, not a deliberate attempt on the part of central bankers to perpetuate the wealth gap.

The simple fact of the matter is that the proverbial “toolkit” for central banks doesn’t contain many implements capable of directly benefiting Main Street. The problem is that the transmission mechanism from monetary policy to the real economy isn’t nearly as efficient as the channel through which the same policy actions work on financial assets.

For example, when you drive investors out the risk curve and down the quality ladder, you ensure that corporates have ready access to capital, but if they simply use the proceeds from debt issuance to buy back their own shares (as opposed to raising wages or investing in productive capacity), all you’ve done is levitate the value of the assets which are disproportionately concentrated in the hands of the wealthy. Because higher-income groups have a lower propensity to consume, those gains are simply hoarded.

Meanwhile, corporate leverage rises, as the cost of debt becomes increasingly attractive, leaving balance sheets in poor shape to handle a downturn should one ever materialize. The risk then, is that over-leveraged corporates end up needing bailouts, and we find ourselves facing a familiar dynamic wherein profits are privatized, but losses socialized. That can further fuel resentment among the lower- and middle-classes. Airlines became the poster child for this in the COVID crisis.

Main Street gets virtually nothing in the equation outlined above, although as I’m always keen to point out, in the absence of Fed action in 2008, the entire global financial system would have ceased to function and the ATMs would have gone dark – literally.

In any case, the point here is that standalone monetary policy reached the point of diminishing returns years ago. Coming into the COVID crisis, all central banks were doing was doubling and tripling down on the policies that perpetuate inequality, and pleas from the likes of Mario Draghi for fiscal policy to step up fell on deaf ears year, after year, after year.

As the flow chart above from Morgan Stanley illustrates, this was playing out alongside “big picture” (if you will) trends that, on net, exacerbated the situation, galvanizing public opinion and therefore raising the stakes for politicians who need votes.

“Trade, tech and corporate titans have created waves of disinflationary pressures while contributing to the decline in wages/GDP as well as income distribution issues”, Ahya writes.

(Morgan Stanley)

As Jerome Powell has repeatedly pointed out, the COVID crisis has disproportionately affected lower- and middle-income groups.

Small- and medium-sized businesses have been hit the hardest, and workers in industries known for lower wages saw the largest job losses due to the nature of the crisis.

After the crisis abates, political pressure will likely mount to ameliorate inequality and that will mean addressing the “3 Ts” mentioned above (trade, tech and corporate titans).

Of course, all of those issues were already under scrutiny. Donald Trump built virtually his entire election campaign in 2016 on the idea of “righting” historical trade “wrongs” and there’s bipartisan support for reimagining globalization, even if most lawmakers realize Trump’s approach has been a bit ham-handed. Similarly, there’s bipartisan support for cracking down on monopolistic practices in tech, and even as Bernie Sanders and Elizabeth Warren were ultimately defeated in the Democratic primary, the backlash against corporate titans will only gather steam going forward.

The COVID crisis has created more urgency around each of those three issues: Trade (because on-shoring and protectionism can now be justified on public health as well as national security grounds), tech (because the same companies which were already in Washington’s crosshairs benefited disproportionally from a world in which social interaction and business activity were confined to computers) and corporate titans, which happen to be synonymous with tech.

Because all of the “3 Ts” have perpetuated the disinflationary impulse, addressing them will have the opposite (i.e., inflationary) effect. Here’s Morgan Stanley’s Ahya:

Tech, trade and titans have been the key disinflationary forces over the past 30 years but have also contributed to a lower wage share in GDP and rising inequality. The discontent about inequality has risen, triggering policy action. Cracks are emerging in global supply chains and slowbalisation trends are being accelerated by geopolitics. The emergence of trade tensions was partly motivated by rising inequality and has already led to scrutiny of the tech and telecommunications sectors. Trade now faces even closer scrutiny after the outbreak of Covid-19, given the need for more resilient local supply chains, especially in areas such as pharmaceuticals and medical equipment. Fears have risen that continuing technological change combined with workplace automation will widen the skill and income gap.

This is all set against a potentially explosive policy mix. COVID jolted fiscal policy out of its long slumber. Now, it’s not just awake, but is in fact wide-eyed, and riding a helluva coffee high.

“The scale and speed of the fiscal response have been breathtaking”, Morgan Stanley writes, noting that in addition to exploding deficits, policymakers “have now enacted direct transfers to households”. The visual shows the relative size of deficits during the two crises (orange and red, with 2020 projected) and the same figures for the two years leading up to the pandemic (blue and teal).

At the same time, central bank balance sheets are obviously exploding.

The following table from Morgan Stanley is eye-popping. There’s nothing “new” or novel about it, but it never ceases to amaze that on most estimates, the “Big 3” plus the BOE are seen increasing the size of their collective balance sheet by nearly $13 trillion by the end of next year. And that assumes the BoJ doesn’t step things up materially, which they very well may.

(Morgan Stanley)

Crucially, Morgan notes that while the COVID recession is set to be much more severe than the financial crisis, they also believe it will be shorter, which means there’s less runway for the market and various economies to “absorb” (if that’s the right word) trillions in relief and stimulus before activity picks back up.

I discussed all of this last week in “Here’s A Thought: What If (Almost) Everybody Is Wrong?“, a piece that featured the following instant classic quotable:

When you consider the above with the sheer quantum of stimulus already injected into the veins of the still slumbering economy, it is possible that we’ve already overstimulated this sleeping beast, and that once it wakes up, it will rip out the IVs, eat the nearest nurse and run snarling through the hospital lobby and out the front door.

That, in essence, is the longer-run concern about inflation. Morgan Stanley isn’t as colorful about it, but the message is the same.

For Ahya, upside threats to price stability will be a real thing again once the initial near- and medium-term deflationary shock from the COVID crisis is behind us.

“The forces which will bring about inflation are aligning”, he says. “We see the threat of inflation emerging from 2022 and think that inflation will be higher and overshoot the central banks’ targets in this cycle”.

Read more: Richard Koo Details ‘The Many Irreversible Impacts Of COVID-19’

22 comments on “Why Morgan Stanley Sees ‘The Return Of Inflation’ After Coronavirus Crisis

  1. This does create an interesting political conundrum in that an inflation caused by systemic central bank effects will be politically attributed to deficit spending. Less deficit/fiscal spending being a cause of central bank activities/response.

    • 40 years of tax cutting has proved to be ill advised.

      • Correct. Using our tax base for political reasons to redistribute wealth was always a bad idea. The US has had the highest support for taxes in general of any developed country. Buying votes in the cities during the Depression was humanitarian. Buying votes and campaign contributions with tax reductions and subsidies is just bad policy. We have gone too far and going back will not be possible in any administration. Not going back will be ultimately destructive as well.

  2. Demography + much lower immigration will be huge headwinds, but I think they’re on to something. Of course, Paul Volcker taught us how to tame inflation. Just jack up interest rates to 4% or 5% percent. Problem solved. Who’s in?

  3. Government is way too big.

    • Hard to believe you would argue that in the middle of the worst economic downturn since the Depression. 36 million people have lost their jobs in nine weeks and you’re saying government is too big. I can only shake my head.

      • Why would you be surprised?

        Government being the problem has been the major Republican talking point over the past four decades.

        Not that Republicans in power really care about deficits that they have no intention of shrinking since it would result in their losing power.

        But it is a good enough talking point for the party’s sheep (i.e. true believers) while the powers that be game the system to further favor and entrench wealth.

        Early 21st century American politics are darkly humorous. Powerful elites using grievance lemmings to vote against their self-interest to further enrich an entrench themselves.

        • The GOP has been and still is the minority party. But ever since Reagan “discovered” the supply side model and started buying support with tax cuts, all republicans (odd name because they aren’t really) have climbed on board. Kansas under Brownback has shown the limits of this stupidity and served as the proverbial “canary in the coal mine.” What we will lean from their lesson is problematic.

  4. I did not say that now is the time to cut the size of the government. However, with more than 22 million people working for Federal, state and local government agencies ( not sure- but I do not think this includes military) many who are in minimally productive positions, it has gotten too large, IMHO.

    How about the US privatize more functions, over time?

    If the government seriously looked at privatization or took a serious look at productivity, we would realize how much waste, redundancy and inefficiency exists at all government levels. That process would, no doubt, result in employee reductions- which is why now is not the time.

    However, how about the next time the US is at “full employment”?

    Or is bigger government always better?

    Seems to me that if some of the workers were shifted from government to private employers, it would be a net positive for the economy.

    • Sorry empty BUT advances in robotics and computerization have been displacing workers quickly and the productivity gains are not redistributed through forms of socialization. Capitalism corners itself in escalating income stratification if left as INDEPENDANT in name only.This became a zero sum game. Moving workers to private sector deflates wages further.
      We are at a turning point of modernity. Health care should be thought of as a utility and infrastructure should be a publicly funded forward looking priority. Wealth of Nations not wealth of the greedy individual. They can only fit a certain amount of mega yachts in New Zealand. Many very wealthy admit this has become unsustainable. We could use a wise invisible hand right now.

      • Ok- so I guess if I tell you that I think over population is a huge problem- you would not agree with that, either.

        • A dwindling population would hasten the decline of the American Empire.

        • Most demographers have global population peaking at 11 billion or so by 2040 and falling to 9 billion by 2100. Most, if not all, developed countries already have fertility rates below replacement, and above-replacement rates in most developing countries are coming down fast. Most of the population gains over the next twenty years will be a result of lower mortality rates driven by better public health. Except in the United States, where opiod deaths, death by firearm, and unintentional deaths (doing stuff while under the influence) remain stubbornly high.

    • Please explain why people working for, say, FAANGs or Dow companies, are in “good” jobs while people working in government are in “bad” jobs.

    • The trouble is that privatizing won’t be allowed to cover the biggest, National security will prohibit privatizing the military, even though it’s already about half private and the gouge profits being made by the private contractors eat up much more than any possible savings. Many would like to privatize social security but who you going to appoint to manage the money? Everyone will have their hand out on that one. How about smart government instead of smaller for smaller sake. The reason its so large is those 535 elected decision makers we send to DC all want personal stuff for them, their donors, and powerful lobbyists. Multiply that 5035 times and you realized government can never really be small again. Regardless of talk to the contrary republicans are at least as greedy as democrats.

  5. RIght now the Federal Reserve would get down on their collective hands and knees to have an inflation problem in 2022. Since they are pinned to the zero bound, they can raise rates 500 bps and be at the average rate over the last 30 years. I find it hard to believe coming into the 3rd quarter of 2020 that things can bounce that quickly. The damage to the economy has been far reaching and systemic. The economy will rebound, however, it may not be as quick or easy as some assume. Open table estimates 25% of restaurants will never reopen. Frankly that sounds optimistic to me. There is a gigantic deflationary genie let out- 10% unemployment at year end would not suggest wage pressure- and wages make up a huge proportion of prices. I have heard a lot of employers implementing outright wage cuts now….The output gap right now is enormous, and even at year end if all goes well it will still be very large. Inflation not likely under this scenario.

    • Everyone seems to be focused on the demand side of inflation. If you get 20 to 30% of businesses shuttering completely, inflation will come from the supply side. Fewer suppliers, less competition. If the suppliers shutter faster than demand, you can still lose some demand and have inflation.

  6. Very good writing with a nice understated easter egg near the end. Keep up the good work.

  7. The debate will heat up on whether it is different this time. The one observation is that inflation options market is not discounting inflation, whether that is wise or not will only be judged in time.

  8. Mike Aston made the point that inflation is the rate of change. After the large demand shock is cleared, the rate of change of prices is a one way street.

  9. All governance systems ultimately fail as those who have power become corrupt which in turn creates a wildly unequal distribution of wealth that ultimately brings the whole system down. It’s not just the public sector that is inefficient. Large corporations are filled with problems that usually get worse with size. The more monopolistic, the longer they last. What is government but a monopoly, the cost of whose output is a tax on its citizens. As individuals we are caught between private and public monopolies over which we have little, if any, control.

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