Investment Strategy:  Second Quarter 2021 – Inflation: Whose tiger and whose tail?

“Inflation is the tiger whose tail central banks control. This tiger has been stirred by the extraordinary events and policy actions of the past 12 months. It is possible that, as vaccinations are rolled out and some degree of normality returns, inflation will return to a stable state of rest…But, for me, there is a tangible risk inflation proves more difficult to tame.”

Andy Haldane, Chief Economist. Bank of England

When scrolling through the economic play book in the wake of the Global Financial Crisis, commentators were quick to raise the spectre of a rising inflationary pulse as massive stimulus packages were thrown at an economy in absolute, and real, peril. Yet in the decade or so that has followed, the one thing central banks have found difficult to create has been enough inflation to meet their own inflation targets. This ‘missing’ inflation has, in part, led to the Federal Reserve to change its target from a fixed target rate at a point in time, to one which seeks to achieve inflation that averages 2% over time, which implies a willingness to accept periods of higher than average inflation without any policy response. So, are central bankers about to let the inflation tiger run riot?

Crisis? What (kind of) Crisis?

Whilst there are similarities in the policy response between today and during the Global Financial Crisis, their root causes are very different. 

The global financial crisis saw a collapse in demand from an overheated housing and financial sector which duly collapsed in on itself, in the process destroying demand as balance sheets in both the corporate world, in particular those of banks, but also those of households, weakened significantly. This required a slow and long process of balance sheet repair that suppressed consumers’ willingness to buy large items, such as houses or cars. It did not dampen services, such as broader financial services, retail and leisure that continued to grow and accounted for 80% of UK economic output in 2019 and all those associated jobs.

The Covid crisis was a health crisis. This forced an otherwise still healthy economy to simply, well, stop. As lockdowns rose, down went the supply of consumers willing to go about their normal practices of spending in restaurants, pubs, holidays and all the many things in between. Once that supply of consumers gets let back out, so too will pent up demand – potentially in short order. In the Covid crisis, it was the government balance sheets, funded via central bank bond purchases, that took the strain.

The policy response has been different too, with a shifting from a monetary to a fiscal policy response. During 2007-09, it was monetary policy in the form of ultra-low interest rates and QE fuelled liquidity, which essentially fed its way into asset price inflation, coupled with government imposed fiscal austerity measures that formed the policy backdrop. 

In this crisis, a combination of already low interest rates and government bond purchases by central banks could only go so far and central banks passed (& encouraged) the baton to be taken up by government spending, through measures such as furlough schemes and support packages.

Base Jumping

We can expect to see inflation numbers rising in the near term given they are comparing prices to the equivalent point of 2020 when the economy was locking down. Oil prices grabbed the headlines by turning negative in April 2020, so an oil price today hovering around $65 will clearly have a positive impact to an inflation number. Commodity prices are making a comeback too, which will help spur an inflationary pulse. Low inventories have seen base metal prices rise and whether it be torrential rains in Brazil disrupting soy harvests or frozen swathes of Kansas causing crop damage, global food prices are now at their highest for six years. 

There are other near-term issues to contend with even if their impact is likely temporary. Headlines about shortages of goods, whether VW or Ford cutting production because of semi-conductors, or rising costs of freight rates all point to a less efficient supply chains and the threat of rising prices. It is these temporary inflationary pressures which central banks are well prepared to look through as high unemployment, low demand and elevated uncertainty prevail.

The Inflation Playbook

The case for…

The inflation camp argues that the policy response to the pandemic inevitably sows the seeds of future inflation. Central banks, chastened by their inability to hit inflation targets will now let the economy run hot and mis-time the need to restrain growth. Fiscal stimulus directing money straight into the hands of consumers creates a sugar rush of consumption led economic growth that is not controlled through central bank interest rate policy. Too high a focus by central banks on job creation and a false confidence in this tag-team policy response brings greater growth and inflation volatility, which feeds into a weakened currency and inflation on the rise.

The case against…

There are some solid arguments countering the case for rising inflation. Whilst recognising that inflation may spike temporarily as economies re-open, growth will ultimately fade and, with it, inflation expectations. A combination of too much debt; a deflationary cloak of ageing demographics, disruptive technology pushing down prices and a de-unionised labour force with limited real capacity to demand wage increases are all long term structural deflationary forces that will win out in the long run.

Wait for it…

Economic recovery and some near-term inflation are not only anticipated but already being priced into markets. As inflation rises and economies begin to heat up, a calm but firm hand will be needed by central bankers as markets test their resolve in allowing economies to heat up in a low interest rate world. Tightening too early, thereby choking off the economic and jobs recovery, will trigger a stop/start cycle of low growth and recurring sugar-rush support measures.

Tighten too late and inflation may get rooted in price and wage expectations and currency volatility. Whilst the threat of an inflation inducing policy error would appear greatest in the mid-term, this will get subsumed in the near-term demand for economic growth and job creation.

There is currently no inevitability in either outcome.

Those protagonists that argued inflation was an unavoidable consequence of the policy response to the financial crisis found themselves red-faced. To us, what appears most sensible is to begin preparing for the worst but expect something better. 

In the tussle between central banks and inflation, the first hands in a long night of poker have just been played.

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