To propose a return of inflation is to be inflammatory. Investors are committed to a deflationary thesis — and such is their fervour that many believe inflation cannot return in any circumstance. Yet if we look beyond today’s demand shock from the Covid-19 crisis, the forces driving the disinflation of the past 40 years appear to be in retreat.
With the benefit of hindsight, 1981-1982 was one of the great turning points in markets and economics. The peak of inflation and its subsequent relentless decline coincided with the start of globalisation and the greatest bond bull market in history.
Central banks led by the Federal Reserve under Paul Volcker became more sophisticated, more successful and more trusted. Central bank independence followed this success as governments gained trust in the effectiveness of monetary policy, further strengthening bankers’ inflation-fighting credibility.
The growth of outsourcing reduced the cost of labour and production, adding to downward pressures on prices. The sharp rise in the pool of global savings pushed interest rates lower, driving down the cost of capital. All of these factors combined to deliver a rolling wave of disinflation that has washed over the global economy for nearly 40 years.
But today appears like a mirror image of the early 1980s. We have moved from inflation peak to deflation trough. Globalisation may not be in reverse but the character of it appears to be changing. The corporate goal is no longer a single-minded pursuit of the lowest cost of production. Environmental, social and political factors are playing an increasingly important role. These factors add cost.
In this specific crisis capital has also lost out to labour, as Charles Goodhart and Manoj Pradhan have noted. The protection of the individual has been elevated over profit. Promoting human safety is the obvious and humane response to the circumstances we face, but it goes against the absolutist belief in free markets that has been ascendant over the past 30 years. This event has the potential to change society’s priorities. Labour’s pricing power could be lifted in the years ahead for economic or political reasons.
Given the choice of human safety over profit, fiscal deficits are expanding fast to counteract the impact, yet this time there is no sense that this spending will be followed by austerity. If populism is a political movement against austerity, future tax rises may be a long way away. Austerity and its deflationary consequences need populism to die first.
Instead of tax increases, large government spending is being financed by central banks. A form of fusion is beginning between fiscal and monetary policy. Today’s operations are not direct government financing in the primary market, but buying bonds in the secondary market amounts to the same thing.
Despite the above, calls for inflation have been akin to crying wolf in recent years. Quantitative easing after the 2008-09 financial crisis was supposed to be a catalyst for inflation, yet the opposite occurred.
But the difference between the financial crisis and now is stark. The sheer pace of money creation is far greater. The St Louis Fed’s measure of money stock is increasing at the fastest annual rate in 37 years. This is double any moment from 2009-2019. Growth in money supply from the European Central Bank is not far behind.
In recent years, the capacity of money supply to lift inflation, sometimes called the velocity of money, has been very low. But velocity will need to fall even more sharply to offset today’s growth in money supply. Higher inflation appears more likely.
After 2008, the banking system was so damaged that it required structural repair. As banks looked to rebuild, their lending was muted as they rebuilt their capital ratios. Combined with austerity, the money that reached the real economy from 2009-2019 was relatively limited.
Today, banks no longer need to build reserves or capital buffers. Crisis loans extended by banks in Europe are now 80 per cent guaranteed by governments. Governments themselves are writing cheques to individuals and companies. There is an all-out effort to make sure that central bank and government liquidity spills into the real economy.
Inflation is a nebulous phenomenon. It is part mechanics and part psychology, and expectations play a large role. The deflationary narrative of disruptive technology expounded by Brynjolfsson, McAfee et al runs deep. Automation and fears of human redundancy roll together into concerns about demographics and falls in demand. The undertow from these forces is strong.
But these arguments are well understood and discounted. Investors are committed. Cheap deflation hedges no longer exist. Markets have built deeper and deeper positions that could be broadsided by its return.
Even so, there are cracks in this edifice. The speed of a turn in prices is unknowable but the incremental change looks set. A return of inflation may terrorise many portfolio managers, but it should not be feared. If controlled, it could be of enormous benefit for the real economy.
The writer is fund manager at Lightman Investment Management
