The rapid growth in US money supply and rising commodity prices are stirring up fears about a return of inflation. These concerns are reflected in inflation-linked securities, with the 10-year breakeven inflation rate in the US having risen from 0.5% in March 2020 to just under 2% towards the end of 2020.
There are three potential ways that inflation could return.
Route #1 - Inflation is understated
The first is technical: inflation is not being measured properly and is understated by the usual indices.
Admittedly there are problems with measuring service prices during the pandemic. The closure of many establishments has meant that it has not been possible to collect data in the normal way. Instead, some prices have been estimated or simply recorded as unavailable.
The greater source of mismeasurement, however, stems from the change in spending patterns during the pandemic. Covid-19 has forced a shift in spending.
Consequently, the weights used in CPI indices - which are based on normal spending patterns - do not pick up the change in the more restricted Covid-19 economy. Since food prices accelerated and transport prices fell across almost all regions during the pandemic, this biases inflation down.
Clearly there is a problem here which is unique to the pandemic; however, it should fade as spending patterns return to normal in 2021. The distortion created by the coronavirus leads to a modest one-off understatement of inflation, but should not persist.
Route #2 - Households go on a spending binge
The second concern would be that the surge in money growth represents excess liquidity which will create a boom in spending once normal activity is resumed. Stronger demand will force prices higher.
It might seem that people will be keen to get back to normal and spend, but there could well be “scarring effects”. Households could take time to regain confidence. Some spending patterns will change permanently as people choose to work from home more and commute less.
The rise in savings has been seen around the world, but has been concentrated amongst better-off workers and retirees. Low income groups tended to slow or stop saving, while - not surprisingly - the unemployed and furloughed ran down their savings.
Fiscal policy can help in this respect by targeting lower income households. Ultimately though, the excess savings or liquidity in the household sector is likely to dissipate gradually, thus putting less strain on the capacity of the economy and less pressure on inflation.
Route #3 - A supply side shock
The third concern is more long term and reflects the structural impact of Covid-19 on the economy.
Coming back to the scarring effects, if there are permanent changes to spending patterns as a result of the pandemic, there will need to be a reallocation of resources. Workers will shift to the sectors which remain in demand. Such shifts are challenging. It may not be easy for a worker to re-skill for the new occupations. They may also have to become more mobile and move, which again can be a challenge for those with families and other ties.
The initial impact of this is deflationary as unemployment rises and can persist for some time. The inflationary threat comes later, when governments and central banks misread the high level of unemployment as being cyclical rather than structural. Excess monetary and fiscal stimulus can then create inflation as the economy’s supply capacity is not as great as the unemployment figures would suggest.
In this respect, the challenge from Covid-19- is not unique. Nonetheless, it is too early to make an assessment of whether it will lead to another major policy error. And this concern is certainly not the driver of the recent increase in inflation expectations in the financial markets. The same applies to fears over de-globalisation and the potential reconfiguration of supply chains post-covid.
In tracking these risks though, we would keep a close eye on wage growth and inflation expectations for signs that the relationship with unemployment is shifting.
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