Will Covid-19 bring back inflation?

Many believe that once economic activity normalises, the combination of stronger demand (as a result of ongoing loose monetary and fiscal policy) and constrained supply (as a result of Covid-19’s impact on supply chains) will result in higher inflation.

We disagree.

There are many arguments for the return of inflation. We tackle some of them below.

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.

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, we expect 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.

Structural shifts also mean sectors such as travel, tourism and hospitality will be less viable as a result of regulations in the post-pandemic environment. For example, airlines are already recognising the long run impact and are restructuring their workforces. Knock-on effects to manufacturing from cancelled orders are causing a ripple effect on employment across the economy. Such scarring effects mean that spare capacity is likely to persist and weigh on inflation.

The impact of a hit to globalisation and productivity

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.  Those higher costs can then lead to higher inflation as firms attempt to pass them on to consumers.

At a more domestic level, the service sector is facing a significant cost in re-opening with restrictions such as social distancing limiting the flow of customers through retail outlets, in cafes or on airlines, for example. For those sectors, labour productivity will be lower and unit wage costs higher, so creating the prospect of higher prices and lower output, i.e. stagflation.

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.