By Robin Marshall, director, fixed income
Given the recent dislocation of global supply chains, some commentators have raised the prospect that inflation will return as aggregate demand recovers because of a negative supply-side shock from the coronavirus and its impact on capacity. Is this a legitimate concern?
Fixed-income markets currently think deflation is a greater risk
There is little evidence in fixed-income markets of inflation expectations recovering strongly. The chart below shows 10-year inflation expectations, as measured by breakevens, have stabilized somewhat after strong policy responses following the government imposed lockdowns, but remain well below the pre-coronavirus shock, and 2% inflation target, levels (note that UK breakevens are based on the RPI, and not the 2% CPI target). So, the challenge for central banks is more about preventing deflation expectations than controlling inflation expectations. The ongoing collapse in the price of oil is further evidence of this challenge.
10-year inflation expectations, measured by inflation breakevens
Source: FTSE Russell. Data as of April 20, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.
We could see a 2010-11 replay of price increases, but without a persistent inflation problem…
Food prices have been cited as a factor in a possible rebound in inflation, but it is important to distinguish between one-off factors that cause a temporary increase in the price level, and a permanent increase in the inflation rate (year-on-year). One-off increases in food, or commodity prices, simply squeeze real income growth temporarily if not supplemented by higher wage inflation and tight labor markets. Indeed, if food prices spike as economic activity resumes later in 2020, post-lockdown, this will compound the squeeze on consumption and activity.
….as recent US experience shows
The chart below shows this for the US in 2011, when CPI inflation rose to a peak of 3.8% y/y, after increases in food, utility and transport prices. But this spike in inflation merely compounded the squeeze on US real incomes, since wage inflation was only just 2% y/y at that point, and did not exceed 3% for another seven years. Thus, after peaking at 3.8% y/y in September 2011, US consumer price inflation rates fell sharply as the real income squeeze caused consumer expenditure to slow (see Chart 2).
US average earnings growth and CPI inflation
Source: FTSE Russell / Refinitiv. Data as of April 22, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The scale of economic contraction from the Great Lockdown reduces inflation risks further
Finally, the scale of the collapse in global demand caused by the Great Lockdown should be borne in mind. The IMF stated last week that it will usher in the deepest recession since the 1930s depression, with a contraction of 3% in the global economy (compared with a contraction of just 0.1% in 2009 following the GFC). The downward pressure on wage inflation from the economic contraction makes building a case for genuine inflation risks in 2020/21 even more difficult.
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