Will Covid-19 lead to inflation?
For financial professionals only
Lockdown has put large swathes of global economies into hibernation. Here in the UK, the economy has seen what is probably the most significant government intervention outside wartime.
One major challenge is simultaneous supply and demand shock. Take, for example, car manufacturing. With factories closed, there is a supply shock with no cars being produced. On the other hand, there is a fall in demand as people can’t buy from showrooms. You can repeat this analogy across many sectors in the economy.
So, what will happen to the supply/demand equation when lockdown ends? If there is surge in demand for goods and the supply side is not able to provide in the short term, then prices may rise rapidly. This is a classic case of what is called demand pull inflation – not enough goods to meet demand.
However, this unlikely to be the case. Yes, there will be some pent-up demand. Most of us will need a haircut! But as the lifting of lockdown is likely to be a more gradual process supply chains may have a period to adjust to increased demand, and inflation from this source may not be a problem.
Another source of concern is the possibility that lockdown extends for a long period of time and the implications for companies and employment. For example, will all the airlines survive or be reduced to a fraction of what they once were? How many jobs will be forever lost? Think of hotels and the like – already jobless claims in the US are rising rapidly. If this is the case, it’s reasonable to assume that there will a surplus of labour until economies recover to their pre Covid-19 levels, and demand for wage rises should not be a source of inflation. Similarly, rising commodity prices could be a problem. However, the recent collapse in the price of oil, albeit as a result of a spat between Russia and Saudi Arabia as well as falling demand means cheaper petrol for consumers, lower freight costs and reduced heating bills. This all suggests a benign inflation outlook from commodities inputs for some time.
Finally, for the more technically minded and those who can remember the 1980s, the monetarist theory of inflation could be resurrected. Simply put, some economists see inflation as a monetary problem. They reason that if there is more money in the economy than goods available, then inflation will result. Monetarists believe that to achieve price stability, money should keep pace with output and that the recent actions by governments will cause inflation.
However, this was not the case after the global financial crisis in 2008 and the onset of Quantitative Easing (QE). QE was intended to put money into the banks and, along with very low interest rates, encourage them to lend. In reality, the banks saw a rise in their reserves, and excess money did not wash around the economy. The government is underwriting incomes and companies, replacing lost earnings and cash flow, maintaining demand and not necessarily adding to it. Time will tell.
In the near term, the return of inflation is unlikely. But it pays to be alert. If, over time, the supply side of an economy has been permanently diminished, and demand does return to previous levels, then this may change.
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