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Bonds News

COLUMN-Inflation Cassandras return at strangest hour: Mike Dolan

(The opinions expressed here are those of the author, a columnist for Reuters.)

LONDON, April 20 (Reuters) - A time of economic collapse, surging joblessness and plummeting energy prices seems an odd moment to worry about inflation, but some investors fear a reawakening of long-dormant price rises may be one long-term fallout from this pandemic shock.

Inflation has been missing in action for at least 12 years, possibly as long as 20, despite repeated warning of a resurgence due to super-easy central bank policies worldwide and near full employment in many major economies over the past decade.

Globalization, digitization and the changing nature of work and demographics have all been cited as reasons why something once feared as one of the great economic ills of the 1970s and 1980s has barely been a factor since.

And its evaporation was a driving force behind lower interest rates, cheaper credit, rising debt and a 30-year bull market in bonds - which by extension slashed GDP volatility and underpinned equity via a higher risk premium.

The worst global recession in almost a century seems a strange time to get worked up about its return.

Investor outflows from inflation-protected Treasury securities have been running at their highest in 7 years, market gauges of long-term inflation expectations in Europe and the United States have plunged below 1% and March’s monthly U.S. core inflation was negative for the first time in three years.

And yet the very nature of the pandemic shock and its long-term implications for debt finance, globalization and corporate supply chains has seen inflation Cassandras pull hair out again.

Deutsche Bank’s April investor survey show a majority see inflation as more likely than deflation over the next 5 years.

Even if you think rising inflation seems fanciful - or even desirable given more immediate deflation worries - Greek myths do show Cassandra’s disregarded prophecies eventually came true.

SO WHAT’S THE ARGUMENT?

The case for a restirring of inflation hinges on three main features of the potential fallout from the coronavirus shock.

The first centres on the vast injection of central bank and government money into economies to offset mandated shutdowns and, unlike after 2008, the likelihood governments and central banks collaborate in keeping down the cost of huge associated debts while hoping to inflate away its future value over time.

The role of central banks is already shifting gear, involving combinations of bond-buying via ever more quantitative easing, talk of capping long-term borrowing costs via yield curve controls and even direct funding of government spending.

QE is already back underway as a reprise of the post-2008 rescue plan. Some form of yield-curve control, already policy in Japan before the pandemic, is now widely expected given its success in the United States after World War Two to limit the cost of war debts. Direct monetization of government debt, though more controversial and akin to basic money printing, is no longer considered taboo among mainstream economists.

And as they have already discussed in ongoing strategic reviews, central banks would be expected to let price and wage growth “run hot” above target for long periods to provide symmetry to years of sub-target wages and inflation.

“Inflation-linked bond markets pricing a 1% annual inflation rate in the U.S. for the next ten years is reflecting the macro experience of the last decade - monetary expansion but fiscal austerity - and not of the next one - big government everywhere you can see,” said AXA Investment Managers’ Chris Iggo.

A second argument is that governments will command a greater share of the economy than previously and be willing to use it more actively. With a political incentive to correct decades of rising inequality between workers and asset holders, some economists assume governments will guide public sector real wage growth higher while central banks effectively turn a blind eye.

Economists at Jefferies doubt the greater use of direct government finance will be abandoned once the pandemic ends.

“Unlike QE, which forced money into the financial system which largely stayed in the form of excess reserves, governments have introduced money much more directly to citizens via cheques, vouchers, tax rebates and to companies via direct and indirect lending policies,” they told clients.

“The authorities will go from a war mitigating the effects of COVID-19 to fighting a war against unemployment.”

The third set of arguments revolves around a rethink of corporate supply chains and globalization, with governments and companies alike warier of reliance on fragmented “just in time” supply chains from around the globe and the increasingly politically charged role of China at the centre.

More “re-shoring” of inputs and supply chains post pandemic may well be a result, with the result of higher costs in exchange for more business and even political security. “Even with rose-tinted glasses on, we can see the global economy will devolve into regional blocs, much more self-contained than heretofore,” economists at TS Lombard argued. “The danger now is that we get the inflation, but without the growth of the Bretton-Woods years,” they said, referring to the immediate post-WW2 period. For markets, higher inflation would typically be good for gold. But for a variety of reasons to do with generalised risk aversion, gold prices are already near 7-year highs. Inflation-linked bonds are not priced accordingly and that maybe where value for the worriers lies. “We really, really like U.S. breakevens at the back end of the curve,” said Societe Generale strategist Sophie Huynh.

By Mike Dolan, Twitter: @reutersMikeD; Editing by Pravin Char

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