The coronavirus pandemic and the measures taken to thwart it, have taken a brutal toll on the global economy.
We heard yesterday that the UK’s GDP could collapse by a third in the second quarter if the lockdown continues for the full three months. And the International Monetary Fund expects to see the weakest global growth this year since the Great Depression in the 1930s.
Oil has crashed. No one is shopping. Unemployment is surging. It all looks very deflationary. And yet, many people (including us) think the end result will be inflation. Why? And how? And what should you be doing about it?
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How the coronavirus shock turns into inflation
There’s a good column from Karen Ward of JP Morgan Asset Management in the FT this morning, outlining how – within a year – the deflationary forces unleashed by coronavirus could be reversed.
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So how does this happen?
It will partly be about oil prices rallying. You might be sceptical about this. After all, despite the apparent best efforts of Saudi Arabia, Russia and the US last week, oil prices are still weak, floating storage tankers across the world are hull deep in the stuff, and there’s still talk in some quarters of oil prices going to zero or below.
As Derek Brower points out in the FT, while global supply might be cut by near-10% or even 20% (assuming countries adhere to the agreement, which history suggests is unlikely), that doesn’t help when demand has plunged by more like 30%.
However, markets are almost never about what’s happening today. They're about the trend. So it’s worth noting that we’ve gone from all-out war, “no price too low” to getting everyone around a table to talk about how the decline has gone far enough and they now want a stable market. That points to a shift in trend – the rate at which oversupply is being added will decline.
The next step is taken when the pain becomes too great and the path of least resistance changes again. At that point, the focus turns to propping prices up, regardless of the cost. That’s when supply starts to rebalance with demand, particularly if demand begins to pick up again as lockdowns end.
In any case, it’s not just about oil, says Ward. “The increase in inflation will be broader across a range of goods and services”. Ward argues that “demand will roar back” once we’re all allowed out of our houses again.
I see a lot of scepticism about this in the comments below her piece. But I think this is flawed – too much “recency bias” (and some weird tribal political biases – some people seem to think there is something Trumpian about even suggesting that the economy will one day claw its way back to “normal”).
We can’t know exactly when coronavirus will be beaten. But it will be beaten at some point. And at some point after that, it will be a distant memory. And at that point most of our old social habits will return with a vengeance.
So business will roar back. It’s only the timeline that’s a matter of debate. And while a recovery by the end of the year might seem highly optimistic from where we’re sitting today, the truth is that people have much shorter memories than most of us are able to imagine.
So let’s assume that demand does come back rapidly when it returns. You then need the supply to rise to match it. However, while supply will come back, it won’t come back at the same speed as demand.
As Ward notes: “it will take some time for dislocations in global supply chains to be resolved.” And there will be less competition in the first instance, due to some companies shutting down during the crisis.
So that’s how we get the return of inflation. Coronavirus and an oil price war knock some of the spare capacity out of the economy, and then the recovery process means we end up having more demand than can easily be met.
Here’s why inflation will hang around
Of course, supply will catch up. The question then becomes – how do we end up with an ongoing inflation problem? And that boils down to the continuing reactions by governments and central banks (which are now once again, basically one and the same thing).
When we come out of this, governments will have spent a lot of money that they didn’t have. So there will be a lot of debt. Where’s the money to repay all that going to come from?
The taxpayer? Forget it. Seriously – forget it. There isn’t enough money in our pockets.
Tax the rich? It won’t make a dent. Tax everyone else? I don’t see that washing politically after we’ve all been well behaved and feeling that glow of solidarity, and are also all itching to go out and spend cash.
So where does it come from? It comes from the central bank; we print it. Why is that inflationary? Because, put very simply, you’re adding new money into the economy permanently and you’re not taking anything out.
More importantly, no one will care at first, because inflation is what we’ve been looking for this whole time. And after the lockdown, governments will want to be in a position to act as beneficent bestowers of good cheer rather than pre-Christmas Eve Scrooges looking to claw back all the money they spent on forcing us all to stay at home.
At some point, inflation will get to a point where everyone does start to care more about that than they ever did about deflation. That will be when we have our next proper financial crisis.
But for now, let’s just worry about the early stages. Because those will be disruptive enough as it is.
We look at all of this (and also how to protect your portfolio from rising inflation) in much more detail in the next issue of MoneyWeek magazine, out tomorrow. Do make sure you subscribe now – I expect this to be one of the most important economic topics of the next decade or so, so it’s worth getting a jump on it now. You can get your first six issues free – plus a free guide to history’s biggest market crashes – right here.
