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We thought inflation was dead. Could Covid-19 bring it back?

Randeep Somel on the prospect of the return of inflation.

Randeep Somel on the prospect of the return of inflation.

Ronald Reagan once said that inflation was as violent as a mugger, as frightening as an armed robber and as deadly as a hitman. If that is the case, then developed economies have not encountered any muggers, armed robbers or hitmen for some time. Could Covid-19 bring them back? Well, the ingredients for this eventuality are falling into place.

 Reagan made that statement as candidate for US president in the late 1970s, when controlling inflation was one of the biggest challenges for governments and central banks. We are a world away from that today, where the bigger danger in the inflation territory is actually deflation, and central banks along with governments are doing their utmost to stimulate the economy by whichever means possible. So far, this has included low/zero rates, buying back government debt and pouring out direct stimulus to combat the latest slowdown caused by Covid-19.

Let´s take one step back. Where did the mugger go? Globalisation ended his career. One by one, as markets began liberalising, there were no pinch points for the mugger to exploit. Whether it was the single market in Europe, the North American Free Trade Agreement (NAFTA) in North America, China becoming part of the World Trade Organisation (WTO) – plus the countless other countries that followed – and measures that were put in place to ease the flow of capital and goods across borders. Global supply chains grew, costs were kept under control, and for every Thailand that developed and saw cost pressures rise, a Bangladesh would enter the family of global nations and offer the mugger no respite. The 10-year US Treasury yield peaked at 15.68% in October 1981, and has been on a downward trajectory since.

But the landscape had begun to shift before the world had ever heard of Covid-19. While free-flowing movement benefited the owners of capital, there were parts of the labour market that had seen wage deflation for nearly 25 years. These were probably the forces voting for Brexit in the UK, Front National in France, Matteo Salvini in Italy, Donald Trump in the US, Jair Bolsonaro in Brazil, and Rodrigo Duerte in the Philippines. A retrenchment of global supply chains has the potential to recreate domestic inflationary pressure. 

And then along came Covid-19. The pandemic has, with dramatic effect, shown the weaknesses in global supply chains, and for the first time post-World War Two, led to governments all across the world closing their borders and airspace. A long-term consequence of this global pandemic may be that localisation of supply chains becomes prominent again, both from companies and governments that will prioritise security and accessibility over costs.

Going big…and the Treasury bear

“If you’re going to go big, just go big,” US President Donald Trump told Treasury secretary Steve Mnuchin. Last week, Mnuchin put together a $1 trillion stimulus package. Wanting a quick passage, the Democrats added a further $1 trillion to the package to guarantee its immediate approval. And there we have the largest stimulus package in US history, nearly three times the size of the TARP package introduced after the credit crises. The financially conservative German government followed with a €750 billion stimulus package of its own, along with countless measures all across the world, including the EU, which has suspended the debt and deficit requirements across the European bloc.

While stimulus measures are required in times of large unexpected shocks, the scale and speed of the stimulus we have just witnessed is unprecedented.  The economic costs of Covid-19 are still unknown, but policymakers have thrown caution to the wind and planned for the worst-case scenario. 

Let's now take a step forward. Once we have returned to some level of normality, and should the slow, but increasingly important trend of trade barriers begin to rise, we could find ourselves in a world with an excess of economic stimulus. Then, we are likely to see some longer-term economic implications.

The death of the Treasury 30-plus-year bull market has been predicted many times.  It will require sustained inflation in the system to force longer term interest rates up.  While our minds could not be further away from that thought today, the ingredients for this eventuality are all just going into the mix. Policy choices have unintended consequences, especially when they are made in times of extreme pressure. 

Those scared of muggers, please take note.

Randeep Somel is associate fund manager at M&G Investments.

This article was originally published in our sister magazine Money Observer, which ceased publication in August 2020.

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