• The London Financial

Inflation in the Wake of Corona?



Introduction - Japan


Thirty years ago, the Japanese economy came to a grinding halt. The world’s second largest economy at the time, which was so strong that it even bought iconic assets like the Empire State Building and Columbia pictures, suddenly stagnated. Since then, for 30 years now, the Japanese government and central bank have been trying to stimulate the economy without much success. The Yen interest rates have been around zero throughout this time, allowing cheap supply of capital and raising fears of inflation. However, the Japanese people preserved cash and did not buy much. Keeping the inflation in Japan down and even raising counter-fears of a destructive deflation.


Inflation and Covid19


If we look at last quarter of century, Americans have experienced an unprecedented value increase in real estate, education and healthcare. In spite of this, inflation levels appear low and stable. This may be explained through China’s role as a global low-cost manufacturer, satisfying western consumers shopping appetite with cheap goods and in turn balancing the basket of goods and therefor the CPI (Consumer Price Index). China further fuelled this by keeping the Renminbi rate artificially low, and by enjoying its 3rd world country status given 100 years ago to provide unreasonable low international shipping rates to Chinese companies, allowing them to ship competitively globally.


In parallel, inflation all but disappeared from the western world in the last 30 years. A significant drop in interest rates was accompanied with a similar reduction in inflation rates and bank governors worldwide seem to have put aside those worries. Fears over inflation occasionally rose again, reaching a boiling point in 2019 when short-term interest rates became more rewarding than long-term. However, in perfect time, the unexpected entrance of the Covid19 pandemic altered attention into a new crisis, normalizing the interest rate curve again and leaving the question of economic stability forgotten.

Enter Coronavirus. Uncertainty created a halt in economic activity. March of 2020, the US responded to the impact of the pandemic by introducing the CARES Act. Regardless of the relief it has given both citizens and supposedly the economy, one must take into account that a fifth of circulating USD was created in 2020. The 2020 federal deficit stands at over $3 trillion, whereas post-great-recession 2009 recorded a $1.5 trillion deficit. Desperate times call for desperate measures, however, this may have been impulsive and heavily driven by Trump’s wish to keep the economy and companies’ valuation high in the short term, even on account of the long-term stability and competitiveness of the American economy.


Consumer behaviour


Especially when looking into change of spending habits pre-corona and peri-corona. Comparing the average American’s spending habits, it is found that the August 2019-2020 YOY change in financial and bills & utilities spending both shifted negatively 30% and 24% respectively. Whereas investments have seen an increase of 42%. At an all-time high, US stock markets are evidence that even if not too much money was injected, it was not injected wisely.


The hike in tuition fees in the USA in the last decade, combined with the decrease in job market, may lead to a drop in youngsters interest and ability to achieve academic education. This may in turn drive prices down and even lead to a country wide closure of many of the new universities and colleges who came up in recent years to accommodate the many students who were seeking education, aided by student loans. If this will indeed be the case, one of the leading causes of price increase in the USA may disappear.


A similar transition may occur in the real estate market. Americans are earning less and are hence less able to support high rents of mortgages, even if the interest of such mortgages is low as it is now. This may turn into a decline in the RE market prices and a resulting decline in CPI and deflationary pressures.


Government policy


However, we must bear in mind the ongoing monetary and fiscal expansion policy of the Fed. Money supply as higher than it ever was, and Americans live in a society which encourages spending. If they will use this capital to increase spending on goods and leisure, when Covid goes away, this can well contribute to a sudden and sharp increase in CPI, fuelling inflation in the USA. Such a scenario will be a new phenomenon in the 21st century and entail the many problems which inflation brings in its wake –


  1. Higher cost of borrowing

  2. Decrease in exports

  3. Business uncertainty



Conclusion


With the public’s access to so much money, will this spike inflation? If so, will government intervention be sufficient to overcome it - what can governments do? Maybe increase taxes, simultaneously combating inflation and the major 2020 deficit? Or increase interest rates? Maybe even implement price and wage control policies? Whatever the reaction, on thing certain is the uncertainty of such a situation – one thing markets definitely don’t respond well to.



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