Inflation: A New Level of Uncertainty

The COVID-19 outbreak has completely altered our near-term economic and social landscape. It will undoubtedly also have many long-term societal and economic effects, which investors are trying to decipher in order to establish effective investment strategies.

One area of particular investor interest has been inflation. For many years, the challenge had been to actually bring inflation up to stated targets. However, investors now are pondering whether a different type of challenge lies ahead. This may seem odd given that the short-term impact so far has been clearly deflationary – intensely so according to the latest US data. Both headline and core US Consumer Price Index inflation slowed markedly in April. Although we are used to seeing big swings in the headline measure (largely driven by energy prices), the 0.7 percentage point deceleration in core inflation was unprecedented. The pandemic-induced shutdown in demand has decimated pricing power in a range of industries far beyond energy (Figure 1).

In light of this data, the recent spike in inflation uncertainty as measured by the New York Fed consumer survey (Figure 2) seems counterintuitive: shouldn’t expectations be converging lower?

There are two very good reasons why a rising inflation scenario is starting to be perceived as a higher probability. Consumers and investors alike are wondering whether the unpreceded amount of debt being issued by governments across the world to fight the pandemic-related economic stress would prove to be the proverbial straw that finally broke the camel’s back. For instance, the global savings glut is diminishing just as new debt issuance is surging, which is unsettling for anyone who is viewing inflation through the monetary lens. This likely has more than a little to do with the fact that gold has been shining much brighter of late.

The other plausible argument for higher future inflation goes back to what is often described as a process of de-globalization. After nearly three decades of continuous trade integration, shifting labor cost structures, the trade war and now COVID-19, arguments favoring a re-assessment of global supply chains are gaining ground. There is tremendous uncertainty and little agreement about the extent to which supply chains will actually change or how quickly. But a broad agreement is emerging regarding the direction of travel: toward less integration, more domestic production and shorter supply chains. This could mean supply chains moving to higher cost locations, which would in turn generate a degree of cost-push inflation that producers and consumers did not have to contend with for a long time.

We acknowledge these inflationary forces, even though the first will likely prove to be more significant for smaller and emerging economies that do not benefit from having a reserve currency. But we also acknowledge the fact that the COVID-19 crisis has triggered an unprecedented wave of technology adoption across a range of industries. Tendencies such as working, learning and availing healthcare from home are likely to be prominent features of a much more “virtual” future. And it just so happens that they speak to precisely those areas that had seen a higher-than-average inflation over the past decade (Figure 3).

The forced adoption of technology due to COVID-19 may prove to be an efficiency-inducing game changer for both the education and healthcare sectors, which could be highly disinflationary for years to come. Should this happen, the societal effects could be very beneficial in terms of equal opportunity (education) and improved fiscal and health outcomes (health services). We could add a multitude of private and government services to the list. There is a chance that the COVID-19 crisis could manifest itself as the ultimate example of creative destruction as societies emerge from the pandemic with a more efficient way of doing things, generating smaller environmental footprints. Yes, some firms will be caught in the fire and some industries will never be the same. But those remaining may very well reveal themselves to be far better and stronger.