Governments and central banks around the world have responded to the economic impact of the coronavirus with the only weapons they have at their disposal. Governments are initiating spending programmes to support households and firms through the pandemic. Central banks have taken interest rates back to rock-bottom levels, implemented lending schemes and restarted efforts to increase the money supply through asset purchases – the now infamous quantitative easing (QE). Many commentators claim such measures will inevitably lead to a period of very high inflation, such as that seen in the 1970s and 1980s. This note discusses whether this is likely and the implications for investors.
Compared to the 2008 global financial crisis, the response to the economic dislocation caused by the pandemic has been, as one fund manager we know put it, ‘breath-taking, positive and necessary’. Unlike 12-years ago, there have been no complaints of indecision or the dragging of feet on the part of the authorities. However, such a ‘breath-taking’ response – involving much higher government spending, ultra-low interest rates and asset purchases by central banks using newly printed money, has raised the spectre of a return to the bad-old days of high inflation. Journalists, private investors and (some) fund managers are sounding the alarm.
To be fair, for over a decade, inflation worries have never been far from investors’ minds. The experience of the second half of the 20th century taught us that pumping extra money into an economy (through devices such as QE) results in rising prices, higher wage claims and accelerating inflation. As the celebrated economist Milton Friedman wrote in 1956 ‘Inflation is always and everywhere a monetary phenomenon’ – that is, an increase in the quantity of money will simply result in higher prices. However, Friedman’s thesis doesn’t seem to have survived into the 21st century; the QE programmes implemented after 2008 did not trigger a surge in prices. Inflation has been missing in action for more than a decade.
Will it be different this time? The stimulus is certainly greater than in the wake of the financial crisis – will it spur a surge in inflation? For investors, the question is vital. High inflation erodes the value of fixed income securities and cash and changes the way investors value the cashflows generated by companies. Hence portfolio positioning for an inflationary environment should be very different than for an era of stable prices.
To address the inflation question, let’s start with what we do know. The first-round effects of coronavirus are indisputably deflationary. Considering the UK, in February this year inflation stood at 1.7%, slightly below the Bank of England’s 2% target. Since then the effects of the lockdown on businesses, workers and consumers has seen it fall further, to just 0.8% at its latest reading. In short, action to head off deflation is certainly justified at present.
It is worth briefly considering the scale of measures taken in the UK to support the economy to stave off the threat of deflation. From the Bank of England these include a cut in the Base Rate to just 0.1%, special loan facilities and an additional £200bn of QE, while the government has produced an alphabet soup of support programs with a combined price tag thus far of more than £120bn. In normal times these steps would certainly be inflationary and, while these are certainly not normal times, what might happen when the initial threat to the economy is behind us?
One argument we have read repeatedly is that once governments get used to borrowing and spending more than ever, especially if this is funded by free ‘new money’ rather than taxation, they will struggle to kick the habit. That is, if they believe there are no negative consequences to unlimited spending, why not spend, spend, spend? Similarly, with central banks, if printing unlimited money has no downside, why not print, print, print?
When considering the likelihood of this, we should consider the following points.
Firstly, from a cold-hearted economist’s perspective, the government’s response to the coronavirus can be viewed as a selfish attempt to stop the economy (and thereby its tax base) shrinking so far that it will have even less to spend in future. Of course, the action is targeted and phrased in very different terms. It is aimed at saving lives, livelihoods and businesses – and easing the misery of those hit hardest by the economic impact of the pandemic. Whatever the reason, it is true that the aim of the policy response to the coronavirus is to minimise any permanent reduction in the potential size of the economy. The government is not spending because it enjoys it, or even because it can. It is driven by the experience that it is better to support consumers and companies across the economic Grand Canyon that the pandemic represents, than it is to try and haul them back up from the bottom.
This of course doesn’t preclude governments from losing discipline and carrying on spending even when such support is no longer required. What arguably will preclude this is the response of currency and bond markets around the world. Both, at present, are giving their tacit approval to the policy measures. This will not continue indefinitely – and certainly not when the effects of the pandemic are behind us. We expect governments and central banks across the developed world to rein in policy support through 2021, any that do not will see the effects on their currencies and bond markets.
Secondly, it is worth briefly considering the mandate and resulting action of central banks. Reading the speeches from the governor, and various Monetary Policy Committee members of the Bank of England, it comes across loud and clear that officials and advisers consider the Bank’s policy role in very straightforward terms. They want to hit the 2% inflation target set for them by the Treasury. So, with inflation running below this level, and the huge deflationary gale of the lockdown blowing in, the Bank has responded as we might expect – by loosening policy. If it were to do nothing, there would be even lower inflation or even deflation. It is no more complicated than that. Will they reverse policy and raise interest rates when inflation rises above 2%? We believe they would. They are not trying to win a popularity contest – they are trying to deliver inflation of 2%, and if that requires rate rises in due course, we will get them.
So, if the accusation is that all the policy measures are pointing in one direction – towards supporting the economy and the price level – we should acknowledge that this is only because the risk to both is to the downside. We should not assume that this will always be the case.
In conclusion, we do not consider it likely that policy makers’ short-term response to the pandemic will drive us back to the inflationary days of the last century. Thus, while we remain vigilant, we do not believe it is necessary to re-orient portfolios to protect against a return of inflation. In the coming weeks we will address the bigger question of why inflation has been missing in action for most of this century. This will inform our views on how portfolios might best be constructed to protect and grow wealth in the decades ahead.
