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.
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.
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.
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”.