Macht die Krise alles teurer?
Inflation after coronavirus

Will the crisis make everything more expensive?

  • Short-term effect of the crisis symptoms clearly disinflationary

  • In the medium term, the persistently low demand and slow recovery will dampen price increases
  • Risk of inflation through protectionism and monopolies

What will drive prices in the post-coronavirus age?

An extremely unsettling situation for Joe Public, and now also a serious problem for statisticians, as empty supermarket shelves and the lack of cinema visits and holidays make it harder than ever to measure inflation. While pre-crisis arguments revolved around the correct combination of goods and services to make up the statistical basket of goods, the biggest problem in the current unprecedented situation is finding any goods or reliable prices to put in this notional basket at all.

The statistics agencies are telling us that the current inflation figures should be treated with caution. At least this problem will gradually disappear as the economy starts to open up. Coronavirus and the current recession are nevertheless likely to have lasting effects on inflation. But which will be stronger: the upward or the downward pressure on prices? And what does this tension between opposing forces mean for monetary policy? We have prepared an overview for you.

An extremely unsettling situation for Joe Public, and now also a serious problem for statisticians, as empty supermarket shelves and the lack of cinema visits and holidays make it harder than ever to measure inflation. While pre-crisis arguments revolved around the correct combination of goods and services to make up the statistical basket of goods, the biggest problem in the current unprecedented situation is finding any goods or reliable prices to put in this notional basket at all.

The statistics agencies are telling us that the current inflation figures should be treated with caution. At least this problem will gradually disappear as the economy starts to open up. Coronavirus and the current recession are nevertheless likely to have lasting effects on inflation. But which will be stronger: the upward or the downward pressure on prices? And what does this tension between opposing forces mean for monetary policy? We have prepared an overview for you.

Anyone who has visited a German market recently will most probably have had a bit of a shock. Strawberries, apples, asparagus and potatoes: the prices have all shot up during the coronavirus crisis. In April, the price of food was almost 5 per cent higher than last year. The increases were most marked for vegetables (up 6.5 per cent) and fruit (up 11.0 per cent), although meat products (up 9.3 per cent) were also noticeably more expensive.

The reason is that the pandemic is affecting the relative scarcity of goods and services, at least in the short term. There have been changes in both demand and supply. In the case of fruit and vegetables, restrictions on seasonal workers entering the country mean that harvests will be lower than last year. In meat processing, temporary plant closures due to COVID-19 outbreaks have also been a problem. At the same time, there has been a rise in demand in individual sectors – at least in the first weeks of the pandemic. The main sectors affected were food and medical supplies, with supply problems and shortages being experienced in both..

And yet: inflation in Germany slowed significantly in April. Although consumer prices rose sharply in February (up 1.7 per cent) and in March (up 1.4 per cent), growth slowed in April and was just 0.9 per cent higher than in the prior year. Preliminary figures suggest the increase was just 0.6 per cent in May. The reason for this is that by far the greater part of the basket of goods is being affected by a sudden contraction in demand. As well as clothing and education-related expenditure, this is affecting any kind of consumer spending that is reliant on social interaction, as this has been almost completely halted by the countermeasures taken to contain the pandemic. The fall in energy prices has also dampened prices. Fuel, which still makes up 3.5 per cent of the German basket of goods, was more than 15 per cent cheaper in April than in the same month last year. The slump in global demand and disagreements between the oil producers were among the factors that led to this collapse in the price of oil.

Although caution is still required when interpreting the inflation data, the picture should become clearer over the coming months as the problems with collecting the data outlined above are gradually resolved. Overall, we therefore expect that the short-term inflation trend will be dominated by lack of demand – which means disinflation rather than price jumps.

Auch mittel- bis langfristig keine Inflationsangst zu erkennen

Of far greater importance for the capital markets, however, is the medium to long term inflation outlook. The most important parameters here are

  • the unemployment figures,

  • inflation expectations,

  • price shocks for commodities or food and, most importantly

  • demand in the economy as a whole.

The unemployment rate generally shoots up in a recession, but frictions in the job market mean that it is much slower to fall again. This is clearly illustrated in the US where more than 20 million jobs were lost in April alone. This is almost exactly the number of jobs created over the last decade (see Figure 1). And even though many of these jobs are likely to return, the unemployment rate will remain high for some time, as the lockdown of the economy will only be lifted gradually in the various states and regions. Some sectors of the economy will suffer from reduced demand for considerably longer. In others, demand will stabilise at a far lower level in the long term, due to the enduring changes in consumer behaviour. Higher levels of debt will force businesses to cut costs. In terms of the effect on inflation, there is unlikely to be any upward pressure on wages and therefore no translation of such pressure into higher consumer prices.

Figure 1: A whole decade's worth of jobs gone

Figure 1: A whole decade's worth of jobs gone
Source: Bloomberg, as at 2 June 2020.

This analysis is supported by a historical comparison with the current situation. The kind of economic collapse caused by the measures taken to contain the pandemic has previously only ever been seen in times of war. However, there is an important, fundamental difference. In the current crisis, very little

potential output has been destroyed so there is no prospect of the kind of large-scale reconstruction that drives up wages and, ultimately, also prices. Nor, in contrast to wartime, is there any reduction in labour potential: the people now unemployed will immediately be available for work, once the jobs are there.

The extensive government support packages being provided should largely prevent healthy companies from disappearing from the market, at least in countries such as Germany that still have plenty of leeway in terms of fiscal policy. Upward pressure on wages and prices is therefore also unlikely from this quarter.

Nor are the capital markets currently expecting a surge in inflation rates in the long term. The 5y5y inflation swap rate, which shows what the markets’ five-year inflation expectations will be in five years’ time and is viewed as a key metric by the central banks, has plummeted as a result of the coronavirus crisis. Having been within a narrow corridor either side of the 1.25 per cent mark for the eurozone in the second half of 2019, the rate began to slide downwards from the end of February onwards, in parallel with the equity markets. At their lowest point at the end of March, these long-term inflation expectations stood at just over 0.7 per cent. The figure is now back up to just under 0.9 per cent. However, there are still no signs that the markets are concerned about inflation.

Figure 2: Long-term inflation expectations falling

Figure 2: Long-term inflation expectations falling
Source: Bloomberg, as at 2 June 2020. Based on 5y5y inflation swap

Commodity prices are also unlikely to be a major driver of inflation for the time being. As outlined above, temporary supply and demand shocks are causing distortion (which in some cases is considerable), but these are likely to normalise in the medium term. The price of oil, for example, will recover, and this will be reflected in the short term in higher inflation rates, as they will be from a very low base. Strong second-round effects that are permanently reflected in the core rates (i.e. inflation measurement excluding volatile energy and food prices), are not expected, however. In addition, the proportion of energy costs in the basket of goods has fallen substantially because of the price falls in recent years.

A sudden sharp rise in aggregate demand also now appears unlikely. Quite the opposite, in fact. After the 2008/09 financial crisis, consumers and business reacted with caution, spending less and saving more. And the nature of the current crisis is likely to leave much deeper psychological scars. This uncertainty will have a dampening effect both on consumer demand and business investment. At the same time, we can expect a notable increase in non-performing loans that will significantly curb banks’ appetite for risk. A strong increase in lending, which would have an inflationary effect, is therefore also unlikely in the wake of the coronavirus crisis.

We therefore think the risks of inflation that could arise from the sharp rise in government debt and the swelling of the central banks’ balance sheets are also relatively low.

If there is a threat of inflation, this is where it will come from

Nevertheless, there are risks that need to be borne in mind when considering future inflation trends. Regardless of the price-damping effects described above, there are also aspects that could swing the pendulum the other way. One of these would be stricter regulation of global trade. The past weeks have clearly shown that complex, internationally integrated supply chains are extremely susceptible to external shocks. Although the coronavirus pandemic is undoubtedly a very rare event that is unlikely to be regularly repeated in this extreme form, many companies are nonetheless considering whether they should be returning to more centralised production and value creation.

In addition to the business arguments, the political situation could also increase pressure on them to take such action. The rhetoric currently coming out of the US and China suggests that the ceasefire in the trade war between the two countries is finally over. China’s foreign minister Wang Yi has already warned that the US government is pushing the relationship between the two superpowers “towards a new Cold War”. The calls to US companies from the Trump administration to bring production back onshore, especially in strategically important sectors such as healthcare and sensitive technologies, are likely to become louder.

It is far from clear, however, whether this selective reversal of globalisation would necessarily lead to inefficiencies and cost increases in all areas and thus ultimately to inflation. The technological progress of the past decades has probably ensured that much of the cheap overseas labour (and the sometimes immense logistical effort involved in outsourcing production) can be replaced by automated workflows at home in a way that is more or less cost-neutral.

Although we do not expect to see widespread company bankruptcies – the countermeasures taken by politicians and central banks, at least in the industrialised countries, are too extensive for this to happen – some companies are nevertheless unlikely to survive the coronavirus crisis. This will increase the market power of those that do survive, and give them scope to push up prices. We have been witnessing this phenomenon In the US for some time now. It has even led to the emergence of monopoly-like structures in some sectors. One reason for this is that anti-competition regulation is less strict on the other side of the Atlantic, a fact which is reflected in some products and services being significantly more expensive than their equivalents in Europe. US consumers have to pay more for items such as air travel, mobile phone contracts, cable, seeds and fertiliser.

There is reason to assume that Europe will also pivot to a more proactive industrial policy when the time comes to rebuild the economy. Loosening anti-competition controls would be one possible way of creating European ‘champions’ to counterbalance the US competitors that seem to have become too powerful in some sectors. Any price increases resulting from this policy are likely to be few and far between, though. Experience from the US suggests that it is unlikely that any broad inflationary pressure will emerge from this quarter.

A perceived lack of independence of the central banks and their resultant loss of credibility could pose an additional risk. This could trigger an upward spiral in inflation, especially if the central banks were inclined to allow inflation targets to be missed over extended periods of time because of the increased levels of government debt, i.e. if they fail to take prompt corrective action when prices begin to rise. However we do not believe that the central banks will have their credibility tested in this way by the capital markets within the next two years.

Low inflation, low interest

Despite the risks outlined above, we expect the inflation rate to remain very moderate for the next few years. Factors such as a recovery in commodity prices, or the end of time-limited (value-added) tax cuts (such as those granted to restaurants and cafés in Germany), will translate only temporarily into higher inflation figures.

We therefore see a very moderate picture for interest rates, which can best be summarised as ‘lower for much longer’. In view of our expectation of extremely weak demand and, consequently, very moderate inflation, we see no need for either the ECB or the Fed to raise base rates in the next two years. So, despite the huge increase in government debt, interest rates for German and US government bonds are likely to remain extremely low.

 

A at 05. June 2020