- The second wave of the pandemic means no V-shaped recovery
- But it also prolongs fiscal and monetary stimuli
- Hence, inflation will still accelerate — and probably in the long term as well
Over the spring and summer, I made two forecasts in these pages. One was that the world economy would, subject to there being no second wave of the COVID-19 virus, make a fairly rapid recovery. The second was that the massive monetary stimulus seen almost everywhere in the major economies would by 2021-22 lead to higher inflation and that this would be considerably higher than markets expected.
More than six months after the world began to lockdown, how do these forecasts look?
The first point to make is that with the significant exception of China, the world is seeing a second wave of the pandemic. Most countries are reverting to lockdowns in attempts to control the spread, and it is clear that activity, notably in the hospitality and tourism sectors, will be taking another hit. The V-shaped recovery is definitely not on.
That being said, there is a recovery and it is not restricted to China. Business survey data is somewhat erratic, but the trend is generally, if unevenly, upwards, both in the euro area and in the United States. It varies from sector to sector. In the US, for instance, the ISM manufacturing and non-manufacturing indices are both subdued (although above the 50 so-called ‘boom-bust line’); by contrast the National Association of Homebuilders housing market index reached an all-time high in September and building permits reached a 13-year high in the same month. In general, business and consumer confidence in both Europe and North America are at their highest levels since the pandemic began. Needless to say, this could change if the pandemic second wave turns out to be more lethal and difficult to deal with than the first, but, at the time of writing, this does not seem to be the case.
However, the second wave does nothing to change the forecast of eventually higher inflation. If anything, it strengthens the likelihood.
Statistics from the major central banks show broad money growth slowing over the summer and early autumn. That was to be expected. Broad money growth rates from the late spring and early summer (e.g., three-month annualised broad money growth rates of around 30% in the US in the spring) were not sustainable. However, compared with a year earlier, broad money growth remains rapid in all major economies, ranging from above 16% in the USA and 9-10% in the EA to around 7.5% (a 30-year high!) in Japan. The main exception to this trend is China, where M2 growth has remained stable in the 10-11% range since March; although this is still the fastest since 2017.
More importantly, with economies at risk of slowing down precisely because of the pandemic’s second wave, no government or central bank will take the risk of tightening policy (monetary or fiscal) to any significant degree, for fear of causing further economic harm. If anything, we are likely to see further stimulus, with the Bank of England poised to move to negative interest rates after years of opposing such a move; and the US government preparing yet another fiscal stimulus package. In other words, the substantial amount of liquidity injected into the world economy over the past six or seven months remains and is, if anything, added to. Double-digit broad money growth rates and weak GDP growth is over time not consistent with inflation around 1% or even 2%. This does also seem to be realised by central banks, who, as pointed out in previous comments, are signalling an acceptance of above-target inflation (although they probably do not realise how much inflation is likely to rise).
One key issue looking somewhat further out, is what will happen to inflation over a 5-10 year (or longer) horizon. I am currently reading an excellent book which expects inflation to move higher on a sustained basis and makes a good case in support of this forecast. This is Charles Goodhart and Manoj Pradhan The Great Demographic Reversal: Ageing Societies, Waning Inequality and Inflation Revival (Palgrave Macmillan 2020).
However, there is one point on which I disagree with the authors. They expect the higher inflation will lead to higher interest rates (although not necessarily in real terms). That is indeed what should normally occur. However, in this instance, it may not, at least not initially. This is because governments, having borrowed to fend off the impact of the COVID-19 pandemic, will need to service their debt and, crucially, will at some stage need to roll it over (not to mention rolling over existing, previously acquired, debt). For this, they will want and need low interest rates. But they will also want and need inflation, to erode the real value of the debt. This circle can be squared by instructing central banks to keep interest rates suppressed, not just at the short end, but along the entire yield curve, what is known as financial repression, or, nowadays, yield curve control (YCC). That is accomplished by central banks committing to buy the relevant government debt in amounts necessary to fix the yield at the desired level. For instance, the Reserve Bank of Australia is committed to keeping the yield on the 3-year government bond at 0.25%.
Of course, this probably involves the erosion of central bank independence; but that may still occur in today’s populist environment and we are already seeing attacks on the independence of central banks, not only in the United States.
However, there is (there would be!) a problem with financial repression/YCC. If it is practiced in a period of rising inflation, then any holders of government bonds knows that sooner or later the policy will be abandoned. At that stage (as happened after the Fed/Treasury Agreement of March 1951, which ended nine years of financial repression), bond yields will rapidly rise, causing holders to suffer capital losses. Hence, they will, as far as they are able, attempt to reduce their bond holdings before these losses materialise. But that will put further upward pressure on market yields and increase the necessary central bank purchases, thus hastening the policy’s eventual demise.
All this — higher inflation and financial repression — should therefore be good for other asset classes, such as real estate and equities. But in the longer term, high inflation is bad for everyone, a lesson we would do well to remember.