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 20^th 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 21^st 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. 

We have just read an article entitled, Why printing money to avert a recession is not smart economics. It forms a tiny part of the debate raging at present about the huge sums governments are spending to cushion the impact on jobs, businesses and incomes of the coronavirus lockdown which, as we all know, has caused economic activity to fall very, very steeply. As if to illustrate that fact, as we write, shortly after the 75th anniversary of VE Day, it has been announced that US unemployment has reached 14.7%, the highest level of the whole post-war period.

The FT’s contribution to the debate last week was, Can governments afford the debts they are piling up to stabilise economies? The article involved two economists presenting the opposite sides of the argument: yes, the debts can be afforded, governments of countries with their own currencies, simply write a cheque to themselves. Or, no, governments can print money to cover their costs for only as long as the public retains confidence in a currency.

While the arguments rage, fortunately, for those whose livelihoods or businesses have evaporated almost overnight, governments and central banks have not waited for the debate to be settled. Quite the reverse. The pace at which the authorities have begun doling out loans, issuing grants and cutting interest rates is both impressive and, to those concerned about the consequences of such largesse, deeply worrying.

So, where do we stand? In the medium term will the authorities be viewed like the Lone Ranger – riding to the rescue and taking the necessary action to save the day, or are they serving us all the proverbial economist’s free lunch – which we will pay for many times over when the bill falls due?

The answer is by no means straight forward. It involves arguments about the efficacy and risks of central banks ‘printing’ money, the nature of sovereign debt, the mechanics of credit creation in a modern economy and, that age-old enemy of the people, inflation. We have some strong views which we will develop further over the coming weeks. For now, we set out why we believe governments and central banks the world over had little choice in the path taken, and why we shouldn’t fear an inflationary outcome.

Our starting point is that we should avoid the trap of believing that government finances can be thought of in a similar way to those of an individual business, household or person. They are quite different. Mr Micawber’s famous phrase about happiness resulting from living within one’s means may well hold true for the individual, but it has no relevance for a government or entire economy. As experience from the 1930s shows, if, faced with an economic downturn (and therefore reduced tax revenue) a government attempts to cut spending to ‘live within its means’ it will exacerbate the downturn. If it again attempts to balance its books at this new, lower, level of output, it would again make the economy worse, and so on. In fact, we now know that the opposite is the correct prescription. As Keynes pointed out in his celebrated illustration involving the burying of banknotes in disused coalmines by the public sector for the private sector to dig up – governments have to spend to try to create an upward, rather than downward, spiral. So, whereas to Mr Micawber, increasing spending when things are difficult might seem like a recipe for misery, this is precisely what a government should do, for the good of the whole economy.

Our second point involves the degree of choice that governments have in such circumstances and may help to explain why there was so little debate anywhere in the world about the direction of policy. Put simply, given the fully developed social safety nets in place in the UK as well as other advanced economies, it seems certain that governments would be destined to go deep into deficit even if they chose not to ramp up spending to cushion the economic impact of the coronavirus. One way or another, the public purse foots the bill. By greatly increasing spending now, governments hope that some of the costs, in unemployment and other benefits, as well as some of the shortfall, from tax revenue and VAT receipts no longer receivable, might be avoided. Considering our first point – that without intervention economies would spiral down to a new post-virus equilibrium – it is likely that without intervention, these costs would arise over an extended period, perhaps up to a decade or more, and that the total cost would be higher in the long term. More importantly the human cost in terms of unemployment and lower standards of living would be much higher. So, when considering whether governments should be ramping up spending, we should acknowledge that in reality, there is little choice.

Finally, considering the longer term, we would highlight to those worried about the cost of higher government spending in terms of future inflation or the debt burden on future generations, what the real long-lasting damage of the lockdown has so far been. No factories have been destroyed by enemy aircraft, no productive capacity lost for ever (except, sadly that of those people carried off by the virus). No restaurants that previously were making a perfectly respectable living for those operating them have been judged permanently surplus to requirements going forward. But such businesses may struggle to withstand the short-term impact of their incomes stopping, suddenly and for an extended period. It therefore follows that to consider the government’s pandemic spending as new, additional money, and therefore in some way profligate is to misunderstand macroeconomics. This money is an attempt to put back some of that which has disappeared through lost incomes, lost profits and lost credit creation. Only if it hugely exceeds that lost, will it be inflationary. The risks of that, in our view, are minimal.

Of course, as well as the quantum of additional spending, the method by which it is financed is a subject of hot debate – with the emotive term ‘resorting to the printing press’ conjuring up nightmares of wheelbarrows full of banknotes as hyperinflation destroys buying-power and savings. While a full discussion is beyond the scope of this note, we would point out that deflation is, in most circumstances, a far more destructive phenomena than inflation and it is the former that central banks have been struggling to fend off in the years since the financial crisis. To worry about inflation at this juncture is understandable, but premature.

If, having laboured thus far through the note, you are wondering what this all has to do with investment markets, portfolios and retirement pots, our answer, in a word is, everything. The success of the economy, future growth, corporate profits, dividends and the direction of share prices very much depends on the actions taken now to address the impact of the virus. Similarly, the return on savings, the yield on bonds – and the credit worthiness of such securities will depend on the path of economies and the impact of inflation or deflation on the buying power of those savings. Considering the very short term, we believe that the prompt and aggressive steps taken by governments and central banks explain why share prices have rallied after the initial sharp falls.

A follow up to this note will delve further into this debate and its implications for investment markets and portfolio returns. In the meantime, if you have any comments, questions or feedback we would be delighted to hear from you.