Money for nothing, inflation not guaranteed

Governments and central banks have launched multi-trillion dollar fiscal and monetary stimulus packages to cushion the impact of the coronavirus. While these measures were an absolute short-term necessity, there are concerns about the longer-term implications for inflation.  

Money growth in particular has accelerated sharply in the US, where direct cash injections by the government have caused M2 – currency in circulation and deposits held by households and businesses – to expand by 17.7% since February of this year. Global M2 has expanded by 6.6%. 

So, will this prove the famous adage of monetary economist Milton Friedman that inflation is generated by “too much money chasing after too few goods”? Not if there is insufficient demand. One of the immediate effects of the pandemic was a steep rise in unemployment. Even with jobs returning as economies reopen, we expect longer-lasting implications for the labor market that might affect consumer demand as well as compensation, and hence can influence inflation. 

In July 2019, US Federal Reserve Chairman Jerome Powell said that in the past 20 years, “the relationship between unemployment and inflation has become weaker and weaker” due to the stabilization of inflation expectations. His conclusions are confirmed by other research which found that a significant relationship between inflation and unemployment no longer exists. The change in relationship between US unemployment and wage growth is illustrated in the charts below: 

The supply-side view from the labor market is one of three important ingredients for the inflation outlook, with consumption and corporate behavior being the other two. Typically we would expect to see an economic over-reaction that in turn leads to a demand-deficient recession over time, known as the ‘Keynesian supply shock’. 

The immediate effect of the lockdowns was essentially the cessation of activity in contact-intensive businesses. As consumers spent less on those items, they redirected some of their spending towards other sectors. Some are clear substitutes for the goods and services directly affected: consumers unable to eat out spend more on food prepared at home.  

Other sectors are more complementary: for example, consumers who cannot go to the gym spend less on sportswear. The question is whether, overall, consumers reduce their total spending by more or less than pre-crisis levels in the affected sector. If the forces of complementarity are strong enough, they will spend less, spreading the effects on consumer demand and making them longer lasting. 

This process also has implications for corporate behavior. Elevated levels of unemployment and depressed global demand will force corporates to rethink their business model, hoard cash and cut costs. The easiest and fastest way to cut costs is to reduce investment, implement hiring freezes and dispose of assets, all options being disinflationary in theory. More importantly, research shows that changes in corporate behavior actually kick in after the recession has already begun. 

We expect many of the stimulus programs to be extended over time but with consistently less generous terms given the large fiscal cost. As such, we expect a longer period with elevated levels of unemployment weighing on consumer spending, and corporates being risk averse in terms of hiring and investment. Hence, our expectation for demand-pull inflation is low for the next five years out. 

We think a number of secular trends are relevant to the longer-term outlook on inflation, particularly in globalization and technology. The Covid-19 crisis has exposed some of the vulnerabilities of globalization via disruptions in deep global integrated supply chains.  

Times were already tough for globalization years before the coronavirus hit: the level of growth in global trade volumes fell from 5.5% per annum from 2001-2005 to 1.9% p.a. for 2016-2019. Globalization passed its peak in years ago. In addition, studies on a range of countries have concluded that globalization did have a decreasing effect on inflation, but this effect was found to be quite modest.  

Looking ahead, we expect the trend of stalling globalization to continue. The increasing automation of labor (‘man versus machine’) and a switch to and the current competition of labor-intensive production in emerging markets versus new capital-intensive production in developed markets is something that we would not classify as inflationary. 

New technology obviously had a direct downside effect on the price of a number of retail goods, most obviously audiovisual and communication goods. It seems logical that a steeply rising technology trend also affects non-tech inflation components such as housing, retail trade and education or labor’s bargaining power.  

So, how will differing economic scenarios, ranging from weak growth (i.e. a deep recession) to a strong expansion, affect our inflation expectations? We see four scenarios: 

• Depression: a deep recession for the next three years followed by two years of very moderate recovery (10% probability) 
• Recession and lengthy recovery: a deep recession followed by years of moderate recovery (50% probability) 
• Recession and quick recovery: a deep recession followed by a subsequent return to pre-crisis trend growth to end-2019 levels (30% probability) 
• Full expansion: a deep recession followed by swift recovery and above-trend growth (10% probability). 

Our inflation expectations for both developed and emerging markets for the next five years based on these different scenarios is shown in the charts below. In all cases, we expect some recovery of inflation over the next five years, but only moderately so. 

In all, we don’t expect much inflationary impact from the massive increase in money supply engineered by fiscal authorities and central banks, or from secular forces, at least in the next few years. The disinflationary forces stemming from the disruption to demand will simply be too strong.