US economy

Deflation is a bigger fear than hyperinflation


Ask economists about the causes of inflation and “too much money chasing too few goods” will be towards the top of the list. Coronavirus might seem to have delivered both parts of that cocktail: central banks have printed money, partly to finance government spending, while production of everything from cars to kitchen extensions has collapsed. Worries about inflation, therefore, are understandable. But they are misplaced: the world economy has more to fear from deflation

The collapse in oil prices to unprecedentedly low and briefly negative levels in the US last week shows why deflation is the greater worry. Demand for new goods has fallen even further than the drops in supply, putting pressure on prices. This is most visible in international commodity markets but, less noticed, prices — where they exist — for airlines, clothes and housing have likewise sunk. Food prices, where demand has grown despite supply interruptions, are a notable exception.

Oil is an important input to the world economy, and the collapse in its price will lower costs for business across the world. Labour, however, is the most important and the lockdowns have created a large stock of jobless workers. In some sectors vacancies might bounce back quickly as customers return, but in others restructuring and redundancies will be needed to cope with higher debt loads. Wage hikes are unlikely to prompt higher prices anytime soon. 

It is true that central banks, through their asset purchase programmes, have increased the “base money” in the economy, flooding banks with even more new reserves. They have become massive owners of government debt. Earlier this month the British government became the first to use its overdraft at the central bank to fund spending, rather than selling new bonds. 

The connection between this monetary base and the total supply of money, however, is by no means linear. Just as quantitative easing did not prompt a wave of hyperinflation following the 2008 financial crisis, so this new electronic monetary printing will probably not do so this time either. The collapse in consumer and business spending produces a countervailing force by reducing the demand for the bank credit that makes up the bulk of the money supply.

More long-term worries about inflation come from how governments will manage the debt overhang from this crisis. One estimate suggests G7 debt levels will rise to 140 per cent of national income, an all-time record. Olivier Blanchard, former chief economist of the IMF, wrote last week that while deflation was more likely he “cannot completely dismiss a small probability of high inflation”. He worries that an inflationary boom might take off at the same time that central banks will need to keep interest rates low to ease the burden on government budgets — known as fiscal dominance.

Such a combination is unlikely, but cannot be ruled out. The macroeconomic puzzle will be managing these debts without choking growth or triggering inflation. For many countries the most appropriate method will be debt restructuring; for others it will be other forms of financial repression. Capital controls may make a return, particularly in emerging markets where large capital inflows have been destabilising.

Deflation would make high corporate and government debt loads even harder to manage as interest payments stay fixed but wages, prices and tax payments all fall in cash terms. All this suggests that investors should prepare for another long period of miserable yields on government debt — most likely below inflation. 



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