Could a resurgence of inflation be around the corner?

Sounding the alarm over inflation has become an increasingly lonely activity in recent years — with good reason. In the wake of the financial crisis, the advent of quantitative easing (QE) sparked widespread concerns about the inflationary dangers of expanding the money supply. And yet a decade and more of ultra-loose monetary policy failed to generate much in the way of price increases, runaway or otherwise. Warning about inflation started to sound more and more like doom-mongering and, worse, a denial of the facts.

Economists have been more hesitant to bang the drum for monetary discipline in response to the vast stimulus packages unveiled around the world over the last 12 months. But a reluctance to repeat errors from the early days of QE has morphed into a near-universal agreement that inflation will remain benign. This assumption is now so deeply ingrained in financial markets that the emergence of rapid price increases would generate powerful shocks in virtually every asset class. For this reason alone, it is worth at least challenging that consensus view. There are also signs from various parts of the economy that inflationary pressure may be building more quickly than many anticipate.

Start with the sheer scale of the fiscal and monetary responses to COVID-19. At £895 billion, the Bank of England’s announced purchases of government bonds are now double their pre-pandemic level, while the Federal Reserve is buying assets worth $120 billion every month. The European Central Bank’s Pandemic Emergency Purchase Programme totals €1.85 trillion. Meanwhile, President Biden’s proposed $1.9 trillion relief plan will provide a major fiscal boost even if it ends up being watered down.

The aftermath of the financial crisis showed that stimulus packages do not lead inexorably to price increases. But the money that was created in 2020 ended up at a different destination to that of the 2010s — and a more inflationary one. The early bouts of QE were largely absorbed by financial institutions, bolstering bank reserves and pumping up asset prices. By contrast, the latest round appears to have made it into consumers’ pockets. Household bank balances are now much higher than they were in 2009, and average household debt is below average. At the same time, corporate treasurers have built up record levels of cash.

When the easing of the pandemic allows societies to reopen and consumers to spend, this abundance of cash will naturally exert an upward pressure on prices. In the short-term, this is likely to be exacerbated by restrictions on the supply side. Successive lockdowns have taken a severe toll on the industrial, manufacturing, and leisure sectors, all of which will take time to restore capacity to pre-pandemic levels. Early bottlenecks are already forming in freight and commodities. The price of shipping a standard 40-foot container along a key route from East Asia to Northern Europe rose from $2,000 in November to $9,000 in January. Meanwhile, the price of iron ore has risen by 60% since the start of 2020, and that of copper ore by 25%. These increases will unavoidably feed through to consumer prices.

It is not a huge stretch to imagine a transient burst of inflation in 2021. But what are the risks of this becoming more sustained? An increasing number of economists are warning of structural factors that could transform such a spike into a longer-term trend.

Principal amongst these is the effect of demography. The Great Demographic Reversal, a much-touted book published last summer by Charles Goodhart and Manoj Pradhan, proposes that the drop in inflation since the 1980s was primarily due to the growing working age populations in China and Eastern Europe. This provided a worldwide disinflationary impulse, as globalisation made these workforces available to boost production. The authors argue that both the demographic trend and globalisation are now in reverse, and that this will lead to a sustained period of much higher inflation than markets and policymakers expect.

At the same time, central banks appear to be getting more tolerant of rising prices. In the U.S., the Federal Reserve has committed to allowing inflation to persistently exceed 2% during the recovery from the pandemic. The ECB has emphasised its mandate to support the economic policies of the EU more strongly than the imperative to maintain price stability. Such attitudes risk creating a positive feedback loop that could be difficult to control. If people believe that inflation will be allowed to accelerate, they will bring forward purchases and potentially turn that belief into a self-fulfilling prophecy.

This would be a fine line for policymakers to walk at any time, but it is happening at a point where confidence in central bankers’ independence is more eroded than it has been for years. A recent survey by the Financial Times showed that of the 18 largest players in the UK gilt market, a majority believe the BoE is pursuing QE to finance government debts rather than to meet its inflation target. True or not, that belief has dangerous implications. It risks pegging inflation expectations — and possibly outcomes — to government borrowing rather than central bank action. Historically, such a link has frequently increased both the level, and the volatility, of inflation.

If any of this sounds like a persuasive case for a resurgence of inflation, it should be highlighted that currently it has limited support in economic circles. And yet, from interest rates and government borrowing through to equity prices, much depends on the prevailing assumption that inflation is dead. Hedging against the event that it is wrong could be very valuable.