“Will pandemic be inflationary or deflationary?”
The impact of the coronavirus on inflation is uncertain, as there are simultaneous supply and demand movements that can shift the balance towards more inflation, disinflation, or even deflation. The coronavirus pandemic is more likely to leave a legacy of weak or falling prices for goods and services than to trigger higher global inflation. When we divide the oncoming future of the economy. In the short term, despite measurement problems disruptions to production, falling demand, measurement problems and market outages will occur. In the medium term, several factors suggest that disinflationary pressures will continue to dominate. Thus in the long term, transformations such as deglobalisation or shifts in consumption patterns could lead to structural changes. Early disruption to the supply chain would eventually lead to price hikes but the pandemic brings a much pivotal problem. Workplaces working on the basis of hands-on and one-to-one interaction such as factories, banks, etc. ceased working in office due to the pandemic which calls forth a decrease in income. It was visible that the real problem is a deep slump in demand due to an income crisis. Some believes that once economic activity normalises, the combination of stronger demand (as a result of ongoing loose monetary and fiscal and financial policy) and constrained supply (as a result of Pandemic’s impact on supply chains) will result in higher inflation.
I personally disagree. Supply-side issues may put upward pressure on inflation as firms look to build more resilient supply chains. However, demand will remain weak as governments tackle debt built up during the pandemic, corporates and consumers remain cautious about spending. Passing on higher costs will be difficult and firms will pursue technological solutions with greater ambition. Moreover using inflation as a way to solve debt problems would require a regime change and it’s likely to be politically unethical, thus it’s not a solution used nor considered by authorities. On the other hand concerns about accelerating consumer price inflation are looking increasingly mislaid as pandemic-induced price spikes start to fade while disinflationary trends become more conspicuous in large categories ranging from rent to medical care to college tuition. When the coronavirus first hit, consumers, scrambled for everything from toilet paper to hand sanitiser even as production shutdowns hit film industry and vehicle assembly lines. Unprecedented levels of government income support temporarily boosted consumer spending power, especially for poorer households. Meanwhile, large fields of the economy — including restaurants, airlines, live entertainment, schools, personal services, and medical care — were effectively closed, with few, transactions taking place. The net effect was that the government’s price indexes went haywire. Over the summer, many investors and analysts grew increasingly concerned about broad-based inflation. Some investors hedged against the risk unprecedented amounts of monetary and fiscal stimulus will eventually start to produce price bubbles, prompting them to buy gold, inflation-linked bonds or other assets expected to at least hold their value.
Beyond the fact the virus continues to spread in some parts of the world and fears persist of a second wave later this year, part of the uncertainty is due to the global pandemic lockdowns being unparalleled in their effect on economies.
These opposing movements illustrate the forces of demand and supply that are affecting inflation. In the services sector, for instance, the fall in inflation suggests that demand is declining more than supply, although the sector is likely to have been severely affected by price measurement issues, as discussed below. In contrast, the rise in inflation in unprocessed food (particularly fruit and vegetables) has been abnormally high, indicating a decline in production and a bottleneck as demand remains more stable, since the lockdown did not alter consumers’ basic needs. Prices may also have been affected by a possible increase in demand as consumers stockpiled. The drop in energy prices, meanwhile, reflects a collapse in demand for energy sources as a result of the shutdown of activity in many sectors, such as transportation. Beyond all these price movements, the most distinctive factors affecting the data for recent months are measurement problems and the absence of markets, two factors that may have affected the price of services to a greater extent. On the one hand, the shutdown of sectors means that the prices of their goods and services simply cease to exist. In addition, companies that are closed cannot respond to surveys conducted by statistics institutes; Eurostat itself reports that 35% of prices in April had to be imputed, i.e. estimated using statistical techniques, since they did not have all the necessary information. On the other hand, the set of goods that makes up the price index is no longer representative of average household purchases. As an example, during the lockdown, expenditure on services and transportation plummeted (whereas in normal times, services account for 45% of the index).
The initial signs are that the coronavirus crisis is having a significant deflationary impact on the world economy with both activity and inflation falling sharply. The collapse in demand has hit oil prices, leading to lower energy costs whilst we have seen a deluge of offers from retailers keen to clear the excess stock which built up during the lockdown. As airlines and hotels reopen we can expect more discounting and would not be surprised to see headline inflation rates turn negative in the US and Europe in the coming months. The drop in commodity prices has been similar to that experienced in the last recession and the mid-cycle slowdown of 2015 and signals a period of sustained weakness in US inflation in the coming months. However, as people get back to work and activity improves, many are looking ahead to the next phase of the cycle and foresee a spell of inflation. Stronger demand fuelled by loose fiscal and monetary policy could drive prices higher as the world economy normalises. However, the recovery process really creates a dilemma. “Rising inflation is consistent with a V-shaped recovery,” noted global economists at CitiBank. “But there is little evidence of a sustained pickup in inflation,” economists said, noting the evidence so far confounded the orthodox theory of big increases in money supply leading to inflation. IIf anything, the current dilemma for central bankers is that the effect of the crisis is raising more questions about policies based on consumer inflation targets that now look less likely to be achieved, even as asset prices soar. Major developed-economy central banks have struggled to achieve those targets in recent years and aren’t expected to for at least another three, despite expectations for them to expand their balance sheets to record highs. Such an outcome would mark a significant shift for markets where low inflation has become embedded in asset prices. It has enabled central banks to keep interest rates low and also allowed them to respond freely to demand shocks with looser monetary policy. The so-called “Fed put” (or belief that the Federal Reserve can always lower interest rates to rescue financial markets) has played a key part in supporting risk assets, but has only been possible as a result of the leeway created by low inflation.
Hence, how great is the risk of a significant shift, or a watershed in the behaviour of inflation?
Concerns over a pick-up in inflation are not new. The introduction of quantitative easing (QE) in the US in 2008 was greeted with warnings that money printing would lead to rapidly rising prices. In the event, the concerns were misplaced as, after a commodity-driven bounce in the early stages of the recovery in 2011, global inflation fell back and spent most of the past decade below 2% in the US and eurozone. The problem for central banks has been too little rather than too much inflation.
Will it be different this time?
Despite the idea of, inflation being always and everywhere a monetary phenomenon, the relationship between measures of the money supply and inflation is loose at best.
Rapid accelerations in the money supply are frequently accompanied by equivalent declines in the speed with which money circulates in the economy (known as velocity) to leave overall activity little changed.
The decline in the velocity of circulation after the global financial crisis meant that despite the rise in money growth, inflation did not pick up in response to an increase in demand and quantitative easing. Instead, the extra money created remained in the banking system which saw reserves rise significantly in the wake of the crisis. It did not feed into the economy and price levels.
Some argue that this time is different as the money created by QE is being fed directly into the economy through increased fiscal spending. However, whilst it is true that central banks are creating money and buying government bonds almost as rapidly as public debt is rising, this is not the same as printing money and spending it directly in the economy. QE purchases are made in the secondary market from investors (such as insurance and pension funds) rather than directly from the government through the primary market. The extra liquidity created by QE is going to investor accounts and bank reserves as before. QE helps keep borrowing costs down but does not directly fund governments. Certainly, the scale of QE is larger than in the last recession, as are the increases in budget deficits, but this needs to be seen in the context of a much greater collapse in demand. The government has stepped in to pay wage bills and facilitate loans to keep businesses afloat that would otherwise have failed as a result of the lockdown and cessation of cash flow. The significant fall in GDP which has accompanied the policy and rise in public borrowing bear this out.
In effect, governments are acting to cushion the economy against the impact of the lockdown rather than adding extra demand. Similarly, the increase in corporate bond issuance and lending to companies is not in response to stronger corporate activity. Instead, it reflects attempts to offset lost cash flow, to cover fixed costs, and to build a war chest to get through the lockdown period.
Factors of higher inflation
- Overdoing it: excess fiscal and monetary stimulus
The ability of QE to boost the money supply but little else does not rule out higher inflation in the future. Going forward as activity recovers there is a risk that policy measures — fiscal as well as monetary — will be left in place for too long and will overstimulate the economy.
Politically there will be a temptation to ignore budget constraints and keep the foot on the accelerator so as to leave the pandemic behind and get the economy back to full employment. Clearly, this is a risk and given the uncertainties as we emerge from the pandemic, by accident or design, policymakers could make an error.
However, this would require sustained and significant spending to close the output gap (the difference between an economy’s potential and actual economic output) and create inflation.
Economic slack is significant; unemployment rates have risen to post-war highs with US unemployment at 13.3% in May. We expect the US output gap to reach 9% of GDP this year compared to a previous low of 6.5% in the global financial crisis (GFC). Jobless rates in Europe have not reached US levels, but mainly as a result of furlough schemes; consequently, these disguise the potential slack in the labour market.
As lockdowns are lifted, jobless rates should decline sharply; however, it is likely that spare capacity will persist as a result of a slower pace of demand. After the initial burst of pent up expenditure, an expectation on consumer and corporate caution to increase on concerns of a second wave of infection and a loss of job security — a factor which will limit the pick-up in spending.
- The impact of a hit on globalisation and productivity
Looking further ahead, it is likely that there will be effects from Covid-19 on international supply chains and that the pandemic will be a further hit to globalisation. Global trade has been falling as a share of activity since the GFC and saw a further set-back during the trade tensions of 2019. Covid-19 could accelerate the process of de-globalisation by highlighting the fragility of supply chains. It is also likely to constrain the flow of labour between countries. From this perspective, Covid-19 could help reverse one of the dis-inflationary forces in the world economy. Once activity normalises, we can expect that firms will look to increase the resilience of their supply lines such that a shutdown in one country does not cause the whole chain to fail. There is a case for smaller, but more geographically dispersed plants where production could be stepped up to offset losses elsewhere. Similarly, companies will question the “just-in-time” model of holding skinny inventories which leave little scope for disruption. Such changes can make supply chains more resilient, but at a cost as the extra slack in the system results in a loss of efficiency. Wage rates could also accelerate as a result of the slowdown in migration, which will reduce the supply of labour and hit economies such as the UK particularly hard. These factors do point to some upward pressure on inflation over the medium term, but they have to be seen in the context of weaker demand as over the same time horizon governments will have to tackle the increase in debt built up during the pandemic.
Short-term impact: disruptions to production, falling demand, measurement problems and market outages
The data available between February and May already give us an idea of the short-term impact that the coronavirus crisis is having on inflation. As the first chart shows, in February, when the Great Lockdown had not yet begun in European countries, there was a slight decline in inflation overall, although prices of industrial goods increased significantly due to disruptions in supply chains integrated with China, where many production plants had already closed at the time. Headline inflation continued to decline rapidly, falling from 1.2% in February to 0.1% in May as lockdown measures were enforced in most European countries. The fall can be seen both in energy prices and in the set of goods that determine core inflation. In particular, inflation fell both among industrial goods and in the services sector. In contrast, non-processed food prices have risen rapidly. These opposing movements illustrate the forces of demand and supply that are affecting inflation. In the services sector, for instance, the fall in inflation suggests that demand is declining more than supply, although the sector is likely to have been severely affected by price measurement issues, as discussed below. In contrast, the rise in inflation in unprocessed food (particularly fruit and vegetables) has been abnormally high, indicating a decline in production and a bottleneck as demand remains more stable since the lockdown did not alter consumers’ basic needs. Prices may also have been affected by a possible increase in demand as consumers stockpiled. The drop in energy prices, meanwhile, reflects a collapse in demand for energy sources as a result of the shutdown of activity in many sectors, such as transportation. Beyond all these price movements, the most distinctive factors affecting the data for recent months are measurement problems and the absence of markets. On the one hand, the shutdown of sectors means that the prices of their goods and services simply cease to exist. In addition, companies that are closed cannot respond to surveys conducted by statistics institutes; Eurostat itself reports that 35% of prices in April had to be imputed. On the other hand, the set of goods that makes up the price index is no longer representative of average household purchases. As an example, during the lockdown, expenditure on service and transportation plummeted due to lockdowns(whereas in normal times, services account for 45% of the index).
Disinflationary pressures will continue to dominate
In the medium term, the path that inflation will follow is more uncertain, and there is a possibility that the disruptions to production and supply chains caused by the COVID-19 outbreak will generate upward pressure on prices. However, the magnitude of the decline in demand is such that inflation is likely to remain low over the coming months. In other words, the difference between the evolution of demand and supply in the various markets will continue to generate deflationary pressure. For instance, all the indicators suggest that energy prices will remain below 2019 levels, meaning that they will make a negative contribution to headline inflation throughout the year.
With regard to the price of the goods that make up core inflation, despite the notable surge we can expect to see in consumption over the coming months, we anticipate that it will remain weak and below pre-shock levels for a long time to come due to the impact of the crisis on the labour market, which will limit inflationary pressures. Moreover, the savings rate, which appears to have increased during the lockdown, is likely to remain high compared to pre-crisis levels until uncertainty fades. The high degree of uncertainty surrounding the current scenario is thus affecting the behaviour of firms and households. For instance, in this type of context, households with higher incomes tend to save more as a precaution, which reduces inflationary pressures, as we show below. Using a statistical model, we estimate that an increase in uncertainty has negative effects on inflation and employment in the euro area, as the second chart shows. Specifically, according to the results of the model, an increase in uncertainty like that experienced in recent months would reduce inflation by 1.7 PPS and increase unemployment by 1.1 PPS in the euro area over the next nine months. This result is similar to a study conducted by the Federal Reserve Bank of San Francisco on the impact of uncertainty in the US.
Faced with these disinflationary forces, the fiscal policies deployed during the lockdown and recovery phases will be crucial in avoiding persistent effects on demand and in mitigating the risk of deflation. In this regard, it is of vital importance that the programmes to support temporary staff lay-offs are effective and prevent a sharp and persistent increase in the unemployment rate. Households’ and firms’ indebtedness is another factor that should be taken into account. It is important to avoid a sharp increase in the debt of households and firms in the short term which, in the medium and long term, could lead to a prolonged period of deleveraging of the private sector, since such a situation would hamper its ability to recover. On the supply side, the effectiveness of economic policies will also be key in ensuring the survival of the productive capacity of the economy throughout and after the crisis. In this regard, the fiscal measures (such as state guarantees and tax deferrals for businesses) and the actions being taken by the European Central Bank are playing a key role in supporting production the economy and thus in facilitating a rapid recovery in production when conditions are favourable. The relative success of these supply and demand policies will, in part, determine which way the scales of inflation will tip. If they are effective, they will support a gradual recovery in inflation and mitigate the risk of extreme scenarios such as deflation or a sharp increase in prices.
Besides the fiscal sphere, an analysis of the future path of inflation would not be complete without a discussion of monetary policy. The ECB has responded decisively to this crisis, purchasing large amounts of European public debt and providing abundant liquidity to the financial sector. Will these measures lead to a sharp rise in inflation? To the extent that these liquidity injections serve to uphold supply and to cushion the collapse in demand, they should not lead to an excessive rise in inflation. Moreover, the ECB will be able to reduce the liquidity in the system once the economy improves and inflation is converging towards its target.
Given these factors, in all likelihood inflation will remain low in the coming months and will begin to rise gradually with the recovery of the economy as a whole.
A permanent impact?
Finally, the coronavirus crisis could have effects on inflation beyond the medium term, as it could lead to structural changes in our economies. For example, this crisis has revealed the fragility of global supply chains, which are highly vulnerable to major shocks, and this could lead companies to rethink the geographical distribution of their production structures. Furthermore, at the European level, local production of strategic goods such as medicines and food is likely to be encouraged. This force could reverse the disinflationary effect of globalisation in recent decades (owing to the efficiency gains it brought about). Finally, this crisis could also have a lasting impact on the behaviour of consumers and businesses, which may become more cautious in their consumption and investment decisions, or it could lead to permanent changes in consumption baskets.
To recapitulate, in the short run the ongoing pandemic may result in inflation yet, the Inflationary impact of the pandemic is beginning to fade; the disinflationary impact may be just beginning.
