Could the policy response to Covid-19 lead to a resurgence in inflation?Contributor Jai Malhi
As lockdowns are relaxed it’s plausible that we see a rebound in inflation. Consumers may look to unleash pent-up demand, while companies struggle to get back to full capacity.
Central banks are printing money and governments are showering it round the economy. Government debts levels are eye-wateringly high. It’s no wonder investors are questioning whether a resurgence in inflation is on the cards.
Inflation is caused by an excess of demand over supply. Too much money chasing too few goods. The outlook for inflation thus depends on how Covid-19 is affecting both demand and supply. We would argue that the relative shifts in demand and supply may alter over time. In this piece we argue that:
- The most immediate impact of Covid-19 is overwhelmingly disinflationary.
- As economies re-open the degree to which inflation recovers depends on whether demand is restored quickly and/or supply remains disrupted.
- In the longer-term the impact on inflation should depend on whether policymakers manage demand appropriately. While our central expectation is that policymakers ease off the monetary and fiscal gas in a timely manner, there are risks to this benign scenario that investors should consider.
Inflation under lockdown
Both supply and demand have contracted during lockdowns, but demand has fallen by at least as much as supply in most key categories. This dynamic has led to a period of disinflation. The virus containment measures required globally led to a dramatic decline in consumer spending. With economies on pause, the hit to sectors such as retail, food and accommodation services has been most pronounced. Visa data for the UK shows that face-to-face spending in April fell by 45% year on year. Supply was also disrupted but not by as much as demand in some sectors. An April survey by the Office for National Statistics highlighted that 23% of businesses in the UK were forced to close or temporarily pause trading. While business closures were widespread in the hospitality and recreation sectors, other sectors were less affected and were able to begin reopening sooner. The purchasing managers’ survey of manufacturing new orders fell by more than company inventories, again suggesting that the fall in demand exceeded the supply disruption.
The fall in the oil price also pushed headline inflation lower. The sudden decline in air and road traffic caused fuel demand to fall, while major oil producers initially increased production, leading to a historic decline in oil prices. With energy accounting for around 5%-7% of inflation baskets in Europe and the US, it’s no surprise to see headline inflation falling towards zero. However, with oil prices already recovering, the worst of the drag from falling energy prices is likely to already be behind us.
The composition of inflation baskets also shows why inflation has been falling. Spending on household goods, including food, has remained resilient but the sectors experiencing meaningful declines in consumption make up a greater proportion of inflation baskets (Exhibit 1). It is worth noting that there are some technical issues, which make it difficult to accurately measure inflation in a period like this. For example, it’s difficult to record prices for goods and services that we can’t even buy. Meanwhile, inflation basket weights only adjust roughly once a year and so won’t have accounted for the unique shift in recent spending patterns towards essential goods. This means that for many consumers this period won’t have felt so disinflationary.
Exhibit 1: Headline inflation sector weights
% of total basket
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