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It may not look like it, but inflation is coming our way. Here's how to invest

We’re in the middle of a huge global recession. And central bank money printing didn’t lead to inflation after 2008. So why are we saying that it will now? John Stepek explains why it’s different this time.

The world is facing the worst downturn since World War II, according to the World Bank, with global GDP set to fall by 5.2% this year. Markets this week may have cheered a jump in US employment last month, but the unemployment rate still sits at a staggering 13% (and due to an error in the calculations, was probably significantly higher) and the economy is now officially in a recession that the National Bureau of Economic Research reckons started in February. In the UK, we’re attempting to open the country up again, but while the pubs might be open later this month, we still can’t make any headway on getting children back to school, which promises to make any “return to normal” a tricky task for working parents. And we’re still not much clearer on when or if we can expect any vaccine for Covid-19, which means the spectre of a second wave remains a valid worry.

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Against that backdrop – mass unemployment, plus a slump in demand – fear of inflation may seem a little misplaced. What’s behind it? There’s one simple answer – it’s all the money printing. Central banks across the globe, emboldened by their actions following 2008, have slashed interest rates, embarked on even more quantitative easing (QE) and moved from buying government bonds to all sorts of other assets. We’ve already seen the impact in financial markets. In the last week or so the “smart” money on Twitter has been decrying a fad among small investors using free-to-trade apps such as Robinhood for taking punts on stocks that are technically bankrupt. And yet, given that the Federal Reserve has pretty much outlawed bankruptcy, why wouldn’t day traders take such a gamble? It’s certainly no more outlandish than the craze of a few years back for betting on newly minted cryptocurrencies, or the dotcom madness of 2000.

But what about Japan?

However, that’s asset price inflation, not consumer price index (CPI) inflation – or “real world” inflation. Most people would agree that central bank liquidity has played an important role in the rally, even if they would argue about the precise extent. But there’s an obvious quibble with the idea that this could now feed through into the “real” world, rather than simply boosting financial markets. If money printing leads to higher prices in the shops and higher wages in the workplace, then why haven’t we seen much of this sort of inflation since 2008, when they printed all that money in the wake of the financial crisis? An even trickier question is this: why has Japan been fighting an endless, mostly losing battle with deflationary pressure since its asset bubble burst 30 years ago, despite its extraordinary money-printing efforts since then?

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The first question is relatively straightforward to answer. Money printed by central banks gets into the “real” economy via the banking system. The problem after 2008 is that the banks were bankrupt. They didn’t have the capacity to lend any money – instead, what they needed was time to lick their wounds and fix their balance sheets by gradually recognising bad debts over an extended period, in such a way that wouldn’t reveal their underlying insolvency. So money printing was merely plugging a massive hole elsewhere in the system. Without it, the post-2008 environment, lacklustre as it was, would have turned into something more like the 1930s. In other words, any inflationary impact of the central bank money printing was offset by the deflationary impact of the banking crisis.

What about the stickier problem of Japan? Although Japan’s bubble burst in 1990, Japan’s first experiment with QE in the early 2000s ran into a similar problem as in the post-2008 environment – central bank money printing largely offsetting balance sheet repair by bankrupt banks. The more recent, more aggressive experiment with money printing (known as QQE – quantitative and qualitative easing), only really began in earnest in 2013, shortly after Shinzo Abe’s election, as part of his strategy to reignite the Japanese economy. As James Ferguson of the MacroStrategy Partnership explains, the problem this time is that by this point Japanese banks were among the biggest holders of Japanese government bonds (JGB). If the central bank buys a JGB from a bank, as opposed to another type of investor, then no new money has been created – they’ve just swapped assets. Since QQE began, Japanese bank holdings of JGBs have fallen steadily – but inflation hasn’t been sparked (yet).

It really is different this time

When you understand why QE didn’t “work” before, you start to see why the present situation is quite different. For one thing, the banking system is in much better shape. It’s no longer a yawning deflationary black hole, swallowing up money as fast as it can be printed. For another, this is genuinely new money – it’s not just juggling bond holdings between central banks and banks. As Ferguson pointed out last month, the Fed has already bought nearly $2trn-worth of US government debt (Treasuries) “either directly… or indirectly funding the immediate spending commitments of the Department of the Treasury”. And while Ferguson notes that the widely used M2 measure of money supply has many problems as a statistic, it still seems worth pointing out that it rose by 18% in April. That was the fastest growth rate since 1983 and also far larger than the spike seen in 2008. In other words, money printing on this occasion is getting out beyond the financial system, mainly because it’s being spent by governments to try to mitigate the worst of the shutdown impacts.

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That brings us to the real world, where it’s clear that despite the surge in layoffs and furloughs, many consumers are now in a better financial state than they have been in some time. The picture may well deteriorate as support measures are wound down (though be prepared for them to wind back up if they do) but for now it’s very clear – consumers on both sides of the Atlantic have collectively made big improvements to their balance sheets while under lockdown. In the UK in April we saw the largest repayment of credit-card and personal-loan debt on record – an extraordinary £7.4bn was repaid. Meanwhile, in the US, the savings rate has shot up to 33% of income from just 8%, notes Tan Kai Xian of research group Gavekal.

This is all coming at a time when supply chains are under pressure across the globe, again due to coronavirus. John Furner, the US president and chief executive of giant supermarket chain Walmart, recently pointed out that the price of meat “has picked up over the last few weeks, as plants have been inoperable in certain parts of the country”. Nor does it help that, as Louis Gave of Gavekal puts it, with “the Fed, European Central Bank and Bank of Japan backstopping credit markets, and governments moving to prop up all sorts of businesses, we seem to be entering a world where bankruptcies, at least for big firms, will be stopped”.

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On the one hand, this leads to overcapacity, which is deflationary as it means there’s too much supply. However, as of right now, that’s not an issue. And on the other hand, it undermines competition, encourages governments to protect “national champions” and leaves valuable scarce resources in the hands of inefficient operators, all of which damages productivity and is ultimately inflationary. Jeremy Grantham, co-founder of US asset manager GMO, may have put it best in a recent podcast with Patrick O’Shaughnessy of OSAM: “You have no goods, no services to buy and lots and lots of money to buy it with. So of course, it’s an intrinsically inflationary process. We are cranking out paper as the output of goods and services drops way down and that can easily go wrong”.

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