Advertisement

Here’s why the coronavirus crash is likely to end in inflation

The coronavirus pandemic has led to deflation as the world sits it out behind closed doors. But that will change, says John Stepek. And inflation will take off in a spectacular way.

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.

Advertisement - Article continues below

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?

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.

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.

Advertisement
Advertisement - Article continues 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%.

Advertisement - Article continues below

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.

Advertisement - Article continues below

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”).

Advertisement
Advertisement - Article continues below

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.

Advertisement - Article continues below

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).

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

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.

Advertisement
Advertisement

Recommended

The coronavirus is scary – but it's irrelevant to your investments
Investment strategy

The coronavirus is scary – but it's irrelevant to your investments

The spread of the coronavirus is causing alarm around the world. And, while it could be a serious short-term threat to human health, it’s not somethin…
24 Jan 2020
Money Minute Wednesday 4 December: Britain's economic sentiment and American job figures
Economy

Money Minute Wednesday 4 December: Britain's economic sentiment and American job figures

Today's Money Minute looks ahead to the UK's latest all-sector PMI survey, and America's private payrolls report.
4 Dec 2019
Beyond the Brexit talk, the British economy isn’t doing too badly
Economy

Beyond the Brexit talk, the British economy isn’t doing too badly

The political Brexit pantomime aside, Britain is in pretty good shape. With near-record employment, strong wage growth and modest inflation, there is …
17 Oct 2019
UK house prices hit a new record high – can it last?
House prices

UK house prices hit a new record high – can it last?

Despite the pandemic, UK house prices have hit a new high. John Stepek looks at what’s driving the surge in prices, and what it means for house prices…
7 Aug 2020

Most Popular

Don’t despair on dividends – these companies could be set to bring them back
Income investing

Don’t despair on dividends – these companies could be set to bring them back

The value of dividends paid out by UK stocks has plummeted this year as companies “rebase” their payment policies. But things could soon start to look…
6 Aug 2020
Gold hits the big $2,000 level – are Aim miners about to play catch up?
Gold

Gold hits the big $2,000 level – are Aim miners about to play catch up?

With the price of gold shooting through $2,000 an ounce, the yellow metal looks unstoppable. Things are so bullish, even Aim-listed junior gold miners…
5 Aug 2020
Too embarrassed to ask: what is “real return”?
Too embarrassed to ask

Too embarrassed to ask: what is “real return”?

MoneyWeek's latest "too embarrassed to ask” video explains what a real return is and why it's so important for investors.
5 Aug 2020