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Inflation in unprecedented times

04 June 2020

Adrian Owens discusses inflation expectations in the face of increased nationalism and unprecedented policy actions.

An unprecedented future

There is a consensus view that inflation will be weak, or possibly even negative, over the next 18 months. A conflict arises, however, when looking beyond the next two years. A recent global survey undertaken by Deutsche Bank revealed that while 47% of investors expect higher inflation, 40% expect deflation. In our view, today’s policy actions and future policy reactions indicate a significant risk of higher inflation over the next two years and beyond. Regardless, we believe the market is significantly underestimating inflation risks. After years of relatively modest inflation, the market may shift to a new era of higher-than-expected inflation, and we feel that weaker inflation numbers within the next two years will only increase the risk of policy error. 

In the past few months, we have seen unprecedented debt growth, quantitative easing (QE) and policy coordination between monetary and fiscal policy – and indeed, unprecedented coordination across countries. Covid-19 is changing the economic landscape, and medium-term inflation risks are, in our view, being overlooked. Already, monetary aggregates are rising, which is typically viewed as a leading indicator of inflation. 

Chart 1: Unprecedented levels of debt

Source: Congressional Budget Office (CBO), May 2020

A different type of crisis

To provide some perspective, QE is currently at levels greater than four times what was seen after the global financial crisis (GFC). Similarly, the European Central Bank (ECB) and Bank of Japan (BoJ) did not initiate asset purchases immediately following the GFC, waiting until 2011 and 2013 respectively. This time, central banks have responded to the crisis immediately. 

Fiscal policy responses have been huge, with some countries spending close to 15% of GDP. We estimate that, for 2020, this will cause cyclically adjusted deficits to go above 10% of GDP – or even worse. Again, this is significantly different to what we witnessed during the GFC, when the worst deficits were around 6.5% of GDP in 2009. 

In a speech given on 23 April, Gertjan Vlieghe, a member of the Bank of England’s monetary policy committee, pointed out that what the central banks are doing today is mechanically similar to what was done in the Weimar Republic and Zimbabwe. In his view, there are only two reasons why the outcome in the developed world will be different this time – in other words, why we should not experience runaway inflation. Firstly, the money printing will be only temporary, and secondly, central banks are independent.

We find both of these statements to be questionable, given that QE has not been reduced post-GFC and central banks are only independent as long as the government in power says so. We often forget that the idea of an independent central bank is recent – the ECB only achieved independence in the late 1990s. Therefore, there is room for governments to challenge this independence, especially as the global unemployment rate rises.

Chart 2: Fiscal expansion

Source: National sources, Haver Analytics, CEIC, Morgan Stanley Research forecasts; *China's general government cyclically adjusted primary balance is the augmented balance including both on- and off-budget balances. May 2020.

In summary, the GFC was characterised by slower policy reaction, restrictive fiscal policy, regulatory changes and unique QE design. 2008-2009 was a banking crisis, which is a very different beast to what we are experiencing today.

More than policy 

Aside from the unprecedented policy actions of 2020, we anticipate much larger behavioural shifts could occur in the long term. There is the undercurrent of a move away from globalisation and towards on-shoring, as seen in the nationalist behaviour that many countries have exhibited during the pandemic. Germany, for example, restricted its exports of personal protective equipment, and nearly every country in the world has enacted some sort of border restriction to non-nationals. Countries are putting their own people first, and this may cause politicians to reassess their on-shoring policies going forward. 

Although we cannot predict exactly how this reassessment will manifest itself, many investors have discussed the potential for economic scarring, especially as the likelihood of long-term social distancing increases. This will likely hurt the growth / inflation trade off and impact central banks’ reaction functions. 

The Scandinavian outlier

Inflation aside, these unprecedented times have provided plenty of room to experiment in the fight against Covid-19. Sweden’s authorities have gone against the grain by leaving the economy open, rather than locking down. It has had a higher infection and death rate than its Scandinavian peers; however, its rates are lower than the rest of the eurozone. The lack of lockdown has also allowed the economy to continue to function and the central bank has responded aggressively in terms of fiscal action. This aggressive fiscal action is also seen in neighbouring Norway, which was one of the earliest nations to reopen its economy following lockdown. 

Although it is still early days, we can tentatively analyse the initial data coming from Scandinavia to gauge the economic success of their relaxed measures. Based on the PMI changes between January and April 2020, Sweden and Norway have both been impacted slightly less than their peers. Mobility in Sweden has also declined less than in peers. This may be an indication of further positive data in the months to come. 

Chart 3: Sweden’s different approach to Covid-19

Source: JP Morgan, ECDC, UN, April 2020

Historically, interest rates in Sweden, particularly, have been lower than elsewhere. That has changed more recently, as interest rates around the developed world have collapsed close to zero, with one or two countries flirting with negative rates. Norway and Sweden appear more reluctant to consider negative rates. In the wake of the oil price collapse and the fallout from Covid-19, Norway has also begun aggressively selling and repatriating assets overseas. As the deficit deteriorates, more overseas assets should be liquidated and the proceeds repatriated. In 2020, we estimate that around NOK 382 billion will be purchased, which equates to 11% of GDP – a significant support for the Norwegian krone.


The full presentation and recording can be accessed on our event microsite.


Event Microsite

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