After months of worrying about the baneful effects of COVID-19, investors now have a very different threat to ponder.
It is inflation, something that has not been a major concern in developed economies for decades. What has put it back at centre stage is the combination of vaccines, rock-bottom interest rates and massive government stimulus – US$20-trillion globally, according to JPMorgan.
Thanks to the flood of easy money and the improving outlook for virus control, many countries now appear ready to enjoy one of their most rapid recoveries in decades. The danger is that the coming boom may overshoot their capacity to produce goods and services, leading to rapid price increases and bond market disruptions that could also sink stocks.
In the most recent Bank of America poll, fund managers ranked inflation as the No. 1 threat to markets. Meanwhile, Olivier Blanchard, former chief economist at the International Monetary Fund, and Jason Furman, a Harvard professor and former adviser to the Obama administration, have expressed concern over whether the gigantic US$1.9-trillion economic rescue package engineered by U.S. President Joe Biden will have unsettling side effects.
They fret it will spur a rise in inflation that central bankers will be reluctant to tamp down for fear of sabotaging a still fragile recovery. If so, people and businesses may begin to expect accelerating inflation. Those expectations could feed on themselves to drive inflation even higher, both in the United States and elsewhere, through increasingly strident demands for higher wages and prices.
In a severe case, an inflationary spiral could require central banks to raise interest rates to punishing levels to bring inflation back under control. That would hammer both bond and stock prices.
To be sure, many other experts brush off such risks. They acknowledge inflation will shoot higher in the short run, but doubt it will linger.
“The view that prices will rise isn’t misplaced, but shouldn’t be overstated,” Nathan Janzen and Claire Fan of Royal Bank of Canada wrote this past week.
The RBC economists expect soaring gasoline prices and other factors to push core measures of inflation up to, or above, 2 per cent over the months ahead. However, they figure price increases will slow as lockdowns fade into history and the Bank of Canada starts to gradually raise interest rates in 2022.
If the current debate spotlights anything, it is how little can be said with certainty about inflation. Over the past few decades, economists have often struggled to explain events after the fact.
Consider the long decline in inflation that began 40 years ago. No doubt the brutally high interest rates of the early 1980s helped break the wage-price spiral that plagued advanced economies in the 1970s. However, what kept inflation sliding lower for decades afterward is still being debated. It may have been better anchored expectations, demographic shifts, an increasingly flexible and non-unionized work force or simply the absence of any disruption to match the oil price shocks of the 1970s.
Whatever the reason, inflation kept falling to the point where central banks began to worry about its relative absence, especially as some countries verged on deflation. Inflation persistently came up short of official forecasts over the past decade for reasons that still aren’t well understood.
Then came the pandemic. Central banks slashed interest rates. Governments delivered massive support programs. Maybe that gusher of cash will dissipate without any enduring change to prices and wages. Or maybe it won’t.
In an admission of just how murky the outlook has become, Larry Summers, the former U.S. Treasury secretary, said recently he sees three equally likely outcomes for the U.S. economy – one where a recovery proceeds smoothly with inflation fading back to normal after a brief surge; another where inflation keeps spiralling higher; and yet another where the Federal Reserve slams on the brakes to control inflation and catapults the economy into a deep recession.
At least a few commentators are beginning to dispute the conventional wisdom that says inflation is dead. Charles Goodhart, a professor emeritus at the London School of Economics, and Manoj Pradhan, former head of the global economics team at Morgan Stanley, stirred up the debate last year by publishing The Great Demographic Reversal, a book that predicts the world is on the verge of returning to something very much like the high-inflation 1970s.
“Inflation is coming,” Mr. Pradhan reiterated this past week at an online seminar sponsored by Tabula Investment Management in London.
Mr. Goodhart and Mr. Pradhan contend a major reason for the decline of inflation in the 1980s and 1990s was the abrupt opening up of China and Eastern Europe to global trade. Communism’s sudden end added hundreds of millions of new workers to capitalism’s labour force nearly overnight.
The hordes of new workers acted as a powerful disinflationary weight on wages and prices from 1980 to 2010. Their vast numbers meant labour no longer had any bargaining power. Companies could shift production to wherever people would work cheapest. Inflation withered.
But those demographic trends are now reversing. Working-age populations are shrinking in Europe and China and growing only slowly in North America. Meanwhile, growing numbers of elderly are poised to put new pressures on government spending for health care. Those trends will restore bargaining power to workers and encourage governments to take a live-and-let-live attitude toward inflation, Mr. Goodhart and Mr. Pradhan say.
So far, markets aren’t buying their thesis. Bond yields have remained stubbornly low even on 30-year bonds, indicating few investors see a return of persistent inflation in the decades ahead.
However, the “inflation wall of worry” is growing higher, especially in the U.S., according to Nancy Lazar, chief economist at Cornerstone Macro. She expects headline inflation, now at 1.7 per cent a year, to rip higher and hit 4 per cent in 2022. Inflation will eventually relent, she predicts, but not before rattling markets. “Investors will stay jittery as inflation becomes more volatile,” she wrote.
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