08 Jun 2020
The pandemic has caused simultaneous shocks to both demand and supply in developed market economies. Lockdowns have forced consumers to stay indoors and have suppressed commercial activity, creating a shock to demand, while manufacturing and production also have slowed, creating a supply shock. The uncertainty about the size of each shock and how prices will be affected has led to contradictory expectations among economists.
On the latest episode of The Flip Side podcast, recent episodes of which highlight the effect of COVID-19 on businesses and markets, Barclays Head of Research Jeff Meli and Head of FX & EM Macro Strategy Marvin Barth debate whether to expect inflation or deflation in the recovery period after lockdowns are lifted.
Jeff Meli: Welcome to this episode of the Flip Side. My name is Jeff Meli. I'm the Global Head of Research at Barclays. And I'm joined today by Marvin Barth, our head of FX research and strategy. Thanks for joining me, Marvin.
Marvin Barth: Thank you, Jeff. Glad to be here.
Jeff Meli: We're going to continue our series on the economic and market implications of COVID-19. And this episode we're going to focus on inflation. We've seen some contradictory predictions from economists that many developed economies are about to experience either deflation or a rapid increase in inflation as a result of the virus.
That's about a stark a contrast you can draw. A lot of times on the Flip Side, we talk about much more nuance to issues, but this one is pretty extreme.
Marvin Barth: The existence of these two camps isn't such a surprise, Jeff. Economics doesn't really give us a clear answer for this situation. But I think you're right, the extremities on the two sides are quite interesting here.
What I mean by economics doesn't give us a clear answer is that the pandemic is hitting us with both a demand and supply shock. All the people being sent home, avoiding commercial activity is a huge demand shock.
They're not buying as much, but at the same time, they're also not going to work producing things. So it's a supply shock. And while econ 101 clearly tells us that a negative demand shock lowers prices and it clearly tells us that negative supply shocks raise prices, it doesn't give us a very good answer as to what happens when we have both.
And I think that's particularly true when we have so much uncertainty about how large the shock is. And a good example of that uncertainty is look at the difference between markets' views of what's going to happen to the long run inflation and what's going to happen to inflation according to consumers.
Markets are pricing in a two-tenths of a percent decline in long run inflation expectations while consumers have a four-tenths of a percentage point rise, try and make sense of that.
Jeff Meli: Right. Well, I know which side of the debate I'm on. Deflation. Or at least an extended period of very low inflation. I think that's what we should be worried about. And I don't think we're supposed to start worrying about increases in inflation until proven wrong.
So we just had a global expansion that lasted over 10 years. We had record low levels of unemployment rates, basically throughout the developed world and in all of that no signs of accelerating inflation.
Then we layer in the demand shock that you just mentioned. It's so large and so persistent that I think it's going to depress demand for years, even after supply comes back on. And what we've seen is that persistent disinflation or low inflation caused by insufficient demand becomes a self-fulfilling prophecy.
Consumers expect prices to remain fixed or even drop slightly and therefore that's what they get. So, I think that's kind of like what we've seen in Japan for the last several years is what we should be expecting for the rest of the developed world.
Marvin Barth: Jeff, the most important thing that you need to take away from this debate is that you're wrong. The risks clearly skew to increased inflation here. Seriously, look, no capital is being destroyed.
People are really eager to get back to the life that they had. So, I'm much more hopeful that the economy is going to bounce back far quicker than you're allowing here once the lockdowns are fully lifted, especially if we're lucky enough to have a swift movement towards a vaccine or other cures.
And in the background, we've had this massive, just extraordinary amount of fiscal and monetary policy easing on an unprecedented scale that's helped prevent any deterioration in private sector balance sheets in the meantime, but also is ensuring that we're going to get a huge amount of stimulus coming out on the other side.
Now, policymakers could definitely curtail the inflation risks that come from that. But I don't think that they're going to. They like you seem to be much more worried about the opposite risk, and so I think they're going to err on the side of leaving too much stimulus in the system for too long. And that's going to lead to an overheated economy that will generate sustained above target inflation, which exactly to your point becomes self-fulfilling as expectations adjust.
Jeff Meli: All right, Marvin, it sounds like we've got some healthy room for disagreement here. It should be a good debate. And I want to be clear, Marvin, before we start that we're talking about long run inflation.
Marvin Barth: Yes, because clearly in the short run we've already seen the data. We've had big falls already.
Jeff Meli: And I also want to be clear that we're talking about material deviations from the typical two percent target that Central Banks set when they think about what optimal inflation is.
Marvin Barth: Yes, I agree with that. And I'm not going to constrain myself here. I wouldn't limit ourselves to outcomes like what we see in 1920s Germany or Zimbabwe with hyperinflations.
Jeff Meli: OK. Well, I'm glad, Marvin, to see that you're not constraining yourself in terms of the world of possible outcomes here. So, to me, the argument for low or negative inflation is pretty simple.
We just came out of a decade long expansion. We had record low unemployment rates, not just in the U.S. but throughout the developed world. And we failed, even under those conditions, to reach the typical two percent target that developed market Central Banks set for inflation, never mind surpass it.
Now, we get this massive shock. It's the biggest shock we've had to our economy since World War II, much worse than the global financial crisis. We go from the lowest unemployment rates on record to the highest since the depression, maybe even higher than the depression when all is said and done. The demand shock is so big that oil prices turned negative for a brief period of time.
Marvin Barth: Yes.
Jeff Meli: And now we're saying we have to worry about inflation?
Marvin Barth: Yes, OK. Jeff, I'm happy to admit and I have that short-term demand destruction seemed to be the clear and immediate reaction to lower prices. But I think your argument here is really relying on the demand shock being persistent.
And I don't see a strong reason to expect that significantly beyond the lockdowns. People are really anxious to resume some semblance of normal life. And further, one of the things that's going to come out of all of this is the potential for a persistent negative supply shock, governments all around the world have already committed to unwind all sorts of aspects of globalization to ensure that critical health and national security goods and services are produced domestically.
That's going to remove a lot of the cost efficiencies that globalization brought to us. And that's going to lead to what economists call cost-push inflation, which is not something we faced following the global financial crisis.
Jeff Meli: OK. Well, Marvin, I think official lockdowns are only one part of the story. So people's actual behavior is going to depend a lot on what they perceive to be safe rather than what the official rules are.
And just as an example of that, our data science team looked at activity in Atlanta following Georgia starting to reopen. And they did see an initial bounce in activity for a couple of days, but then it very quickly dropped down to where it was during the official lockdowns I think as people got out and about and, sort of, realized how crowded it was and felt unsafe.
And the second thing is that despite everybody wanting to return to normal, unemployment rates are going to be above 20 percent in the U.S. and extremely elevated throughout the developed world. They're going to take a long time to drop. That's another huge part of the demand shock.
Marvin Barth: OK. I agree. This is not a normal recession. In fact, I think it's important to recognize here that this recession didn't come about because the economy exhausted itself. It came about because a life threatening disease was encouraging people to stay at home, as you pointed out.
You have small kids, so I think you can understand this analogy. If you take your kids to the park, and let them run around for a couple of hours and they exhaust themselves, you know that when you get them home, they're going to be down for hours, right?
But if they're tearing apart the house inside, and you tell them to stop, they're going to stop until you've turned your attention away and then the next thing you know, they're going to be lighting fires in the basement. There's been no real capital destruction here. All the economy really needs is a match to get going.
Jeff Meli: I think you're overstating the case somewhat, Marvin. So, it is true that big companies, particularly those that were on pretty good and solid footing pre-COVID are fine. Maybe even big companies are poised to gain market share and that might have something to say about why the equity markets have performed so well recently.
But I think there has been a lot of capital destruction. It's just been in small businesses. They've lost a lot of networks, knowledge, knowhow, and that's not coming back. We've already seen small businesses going under and I suspect that we'll see more before all is said and done.
Marvin Barth: That's definitely true the longer this goes on. So, if I'm wrong about that then you'll be right in that case. But I just think we're much more likely to see a quicker rebound. And I'm hopeful that the losses you're talking about won't be quite as severe.
And to my point about all you need is a match to get it going, the government through its automatic stabilizers, extraordinary assistance like the $600 a week additional unemployment benefits, it's effectively figuratively handing out matches. And then you add on to that that the savings rate has gone through the roof, giving people a lot of effectively kindling for that fire of consumption to come back.
Jeff Meli: Marvin, I think you're ignoring a psychological effect here. So my kids may be perfectly happy ignoring me, but if I get a fireman that come and tell them scary stories about what happens when you play with matches, I think they're going to behave differently.
And this pandemic is a massive psychological shock. I think people are going to behave completely differently to what we've seen before. So going back to my Atlanta example, I think they're going to be a lot more cautious, slower to spend all that savings. Particularly slow to spend those extra unemployment benefits because they're very unclear on whether or not they would be extended. And, again, that leads to the self-fulfilling drop in prices.
Marvin Barth: I think that's actually a really good point about the psychology, but I would take the other side of it in that, I think it's really an illustration of one of the points we started with about the uncertainty level being sky-high here.
I could easily argue the opposite psychological effect. Notice that the hoarding instinct was the first thing that occurred in economies all across the world. And that suggests the psychological shock that you mentioned, which I agree with you on is big and very different from what we've seen before, is leading to expectations for shortages and higher prices.
As I mentioned earlier, consumers’ long run expectations have risen since the start of the pandemic and actually if you look at their short run expectations, they've risen even more by a full percentage point.
Jeff Meli: Yes. That hoarding phase did exist and it lasted a couple of months, particularly on some like household products or cleaning products that ended up being in short supply, given the specific nature of the pandemic.
But you're referring to a couple of months of survey data that basically coincided with that short-term hoarding of temporarily hard to get products.
I think that the longer term experience we've had, say, for example, following the global financial crisis, we had a much smaller negative shock to the economy but that lead to a persistent decline in long run inflation expectations, including through the strongest phases of a recovery that were fueled by some of the same stimulus programs that you're talking about.
Marvin Barth: OK. Let's take that one percentage point fall in long run inflation expectations that you're talking about. It took a decade of below target inflation to drive that. But I think you should put that in perspective. Long run inflation expectations in the U.S. have stayed in a very narrow range of 2.2 to 3.5 percent since 1994. That's a quarter of a century. They’re currently basically in the middle of that range at 2.7 percent.
Unless we have a very long recession from the pandemic, I just don't see the evidence for a dramatic lower in inflation expectations. And with 3 trillion and growing in stimulus in the U.S., the Europeans just announcing a recovery fund of 750 billion euros that's on top of what all the national governments are spending.
And we have ultra-accommodative monetary policy from pretty much every Central Bank around the world. I think it's unlikely we're going to have a recession that lasts long enough to have the effects on inflation expectations that you're worrying about. Combine all that with the production handicaps that I mentioned earlier, and I'm just much more worried about the upside for inflation, Jeff.
Jeff Meli: Well, I want to talk a little bit about the effects of the stimulus on inflation, because I think I could throw those arguments back at you. Lots of policymakers and pundits said the same thing following the global financial crisis when we were in qualitatively similar circumstances.
We had a shock to the economy. There was fiscal spending to try to get us out of that, plus extraordinary measures from Central Banks like quantitative easing where they purchased lots of bonds.
Inflation hawks came out of the woodwork saying that we were going to get a massive shift in inflation, rates were going to rise. None of it ever happened. Inflation never even got to target. The Fed, U.S. Fed was cutting rates when the unemployment rate in the U.S. was below four percent because even with record low unemployment rates, they couldn't get inflation to their target.
This is not what the textbooks say is supposed to happen during that part of the economic cycle. And at some point, I think, we all have to kind of throw our hands up and acknowledge that the data is saying something different from what theory would tell us.
Marvin Barth: Hey, Jeff, that is a really powerful statement. And I'd really like to run with it. But as one of the people who was not saying last time that inflation was going to go to the moon on QE, I want to address some of the common misperceptions around that and how they're different this time.
I think one of the things that this whole QE equals money printing, equals inflation crowd gone wrong is the importance of perceptions. As long as Central Banks were perceived to be buying assets in the purchase of their inflation targets, consumers and businesses maintained stable inflation expectations.
My worry today is something different. And this is why I have this concern. Their purchases might be connected directly to the government's budget or debt issuance or perceived to be, perhaps because the Central Bank loses its independence or maybe because it adopts this modern monetary theory approach, which does effectively the same thing.
In those circumstances, inflation expectations are not going to stay stable. They're certainly not going to decline like they did in the last decade. Instead, the private sector should rationally anticipate, this is going to generate inflation and that's what leads to a self-fulfilling hyperinflation.
Jeff Meli: OK. So, I think that the likelihood that the European Central Bank or the U.S. Federal Reserve agrees to monetize the debt of their respective federal governments seems to me to be quite a stretch at least at this point.
And so, if that's the trigger, then it sounds like all you just said was a fancier way of saying that this so-called money printing isn't really money printing after all. And we shouldn't be that worried about it.
Marvin Barth: Well, I'm an economist, Jeff. I like to sound fancy. But, look, I'm not saying this is going to happen everywhere or with every Central Bank, but at a time when we're seeing massive wartime debt and deficits without war, it's going to create a lot of pressures on Central Banks that they just haven't experienced in a very long time.
And not every single Central Bank is going to manage that well. And I think that there is a good chance that some country is going to make a mistake and it's going to result much higher than target inflation.
Jeff Meli: Well, look, I think I'd agree with you that the risks of a bad outcome are higher in some areas like take as an example emerging market economies that don't issue the debt in their own currency and that their Central Banks are probably less likely to be independent. But I really just don't think that argument is that convincing for the bulk of the developed world.
Marvin Barth: OK. I'm going to mark that as a small win for me that you agreed with me on emerging markets, so thank you. But I'm not sure you can be so confident about advanced economies.
I really do think these comments were taken out of context. But I want to read to you a quote from Adrian Orr, the Governor of the Reserve Bank of New Zealand and, by the way, remember that the RBNZ was the Central Bank that originated the practice of inflation targeting.
And here's what he said, he said, "Direct monetization I know has been heresy, taboo for a long time, but it's only a long time in our lifetimes. It's not a mysterious issue. It's just not how we've run business."
You take a statement like that in the context of the current policy zeitgeist of erring on the side of growth. And I think there's a real risk that people are going to misinterpret it. And remember that this is all driven by inflation expectations that you can get a self-fulfilling error happening there. And maybe in that case it doesn't lead to a hyperinflation but it certainly leads to significantly above trend inflation.
Jeff Meli: Well, yes, Marvin, I want to go back to this idea that we should be cautious relying on the normal way of thinking about the drivers of inflation. So like I said earlier, the textbook outcome just hasn't panned out and that's been true for some time.
And I kind of feel like most of your concerns line up with the textbook arguments for higher inflation. Yet in reality, what we've seen is actual inflation come in lower than forecast for years. So you actually wrote an article with Christian Keller, our Global Head of Economics on the idea that there is a global factor behind inflation.
And that over the course of the period that you studied we had been overestimating it as an economics profession for the entire time. The same happened after the global financial crisis like I just mentioned.
Marvin Barth: Yes, so thank you, Jeff, for that because that's exactly the point of yours that you made earlier that I wanted to come back to, because I definitely agree there is something deeper going on here. It's an unadmitted fundamental lack of understanding by the economics profession about what really drives inflation.
And, yes, Christian and I did find that over most periods the economics profession, whether it was Central Banks or private analysts were consistently over estimating inflation and particularly they've largely done that over the last 20 years.
But importantly, we also found that there is a component to this that is random walk, that is a part of inflation that is unpredictable. It goes where it wants. And that should really trouble any economist because what that means is that we can't actually predict where it's going to go.
And so, sure, we overestimated it for the last 20 years, but that could easily reverse. That's the nature of a random walk.
Jeff Meli: I wonder if the consistent missing to the downside has something to do with that psychology angle that I mentioned before. So people believe that Central Banks know how to control inflation. We learned it the hard way, in the '80s under Fed Chairman Volcker when he basically crashed the economy to get inflation under control.
And now, it's possible that from a psychological standpoint, consumers believe that right tail to inflation just doesn't exist. So, they know that the Central Banks can get a hold of it. And so, it never factors into their expectations.
You take a distribution that used to be symmetric around sort of a core scenario for inflation, you cut off the right tail and lo and behold, we keep missing to the downside which may, again, be, sort of, self-fulfilling.
Marvin Barth: I think that actually may be a good answer, Jeff. And I think it really highlights the uncertainty that we face here. It could also be that the tails are just fatter than we realize and that we've only experienced one tail recently.
And to your point about people's expectations shifting to one side, it's situations like that that always make me worry about the other one happening because nobody thinks it can happen. And if we look at a broader history of inflation, it's not silly to think about this.
In fact, it would seem silly to argue about whether we're just talking inflation above three percent or below one percent. What about minus 25 percent like during the great depression or 1000 percent a day like it was in Zimbabwe a few years ago.
The scary thing about both of those examples in the current context is that both were related to debt crises. I'm not saying we really will see these outcomes, but we probably shouldn't ignore that they're real possibilities either because sad as I am to admit this, we as economists just don't seem to fully understand inflation.
Jeff Meli: Well, Marvin, ending on examples of minus 25 percent or 1000 percent today inflation seems like a fitting way to end the debate of extremes. Thanks for joining me. We'll obviously have to see how all of this plays out.
Clients of Barclays Research can read more about the economic and market implications of COVID-19 on #virus as well as thematic pieces touching on inflation and the nature of work in rethinking emerging markets and the future of work.
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Jeff Meli and Christian Keller debate about how long it may take for government interventions to be effective in restarting the global economic engine.