Ever since the Great Financial Crisis (GFC), economists, investors, central banks and governments have been anxious (for differing reasons) about an increase (or lack thereof) in the rate of high inflation- a scourge which still scars the memories of those born into the Baby Boomer generation.
Yet, with a few exceptions, generally minor in scale or impact, and outside Developed markets, inflation has been remarkably quiescent, which has led to much debate as to why that may be so, and what could cause a change such that inflation starts to rise materially.
Of course, central bank dogma is now that a “little” inflation (usually stated or assumed to be 2% per annum) is a good thing, with most central bankers having been frustrated by their inability to achieve that target on a consistent basis, if at all. By “inflation” they mean some form of price inflation, rather than the two other basic forms affecting asset prices and monetary issuance.
Now there are murmurings that perhaps the return of inflation is nigh. So, the question becomes: “why?”. If central bank actions to date have failed, what may have changed as a result of which the prophecy may come to pass?
For one thing, the amount of money in circulation (often called M2 usually defined as consisting of actual cash, chequing accounts and demand deposits) has been rising rapidly in many economies, as central banks have literally created it as part of government attempts to try to stave off economic depression in the wake of the pandemic.
At the same time, government budget deficits have widened sharply, with levels of sovereign debt rising rapidly to reach levels generally only seen previously in wartime, raising questions about how such obligations will be met in future in the absence of either significant real economic growth and/or rising taxes.
In such circumstances, governments are also terrified of interest rates rising significantly- the classic central bank response to inflation rising beyond the expected or desired level- as this will increase the cost of servicing nominal debt, as well as be likely to curb the economic reflation necessary to promote growth and reduce unemployment.
All these factors present central banks with a dilemma. If a burgeoning money supply and a return to economic growth cause a rise in price inflation above, say, 2%, what are they to do? How far do they allow the trend to continue? What is the level beyond which inflation leads to economic dislocation? If they raise interest rates, do they not only brake and reverse growth, but put an intolerable strain on government budgets because of the increase in debt service costs crowding out other outlays in the absence of significant tax increase, which are politically unfeasible? At what point do they find themselves as the buyers of last resort of government debt in a frantic effort to absorb issuance and suppress interest rates?
If the answers were obvious, everyone would already have worked them out and be applying them. However, the complexity of how all the factors interact, coupled with a lack of any recent inflation-fighting experience within most central banks, simply increases uncertainty. It is easy to say: “inflation must return!” Yet that mantra has been repeated for over a decade with increasing bewilderment. So, we are left with the thought that, on the one hand there clearly are risks to the upside in terms of a rise in price inflation once the global economy has adjusted to the strains caused by the pandemic, but on the other the immediate triggers are unclear- and will probably only become visible in hindsight.
As in everything we do at Awbury, we aim to be aware of and understand all the potential risks to the downside, factor them into our risk analyses, and continue to ensure that we can manage them effectively. Unanticipated and uncontrolled inflation is simply another one.
The Awbury Team