After 30 years of low inflation, this benign era could end abruptly once lockdowns are lifted and economic activity picks up after the Covid-19 shock (see Figure 1).

While the types of hyperinflation seen in Venezuela (2019), Zimbabwe (2007) and Germany in the 1920s (1923 million mark bills remain a collector’s item today along with photos of when wages were carried away in wheelbarrows) does not look set to reappear in G20 economies anytime soon, they remain warnings of what happens in extremis.

However, price rises of more than 10% a year that can destabilise economies and deter foreign investment remain a potential threat in a number of Covid-19-struck economies and are worrying analysts. Deflation, triggered when prices fall (as they have done with oil) creates another set of problems – a rise in the household debt burden where consumers have borrowed in the past and reduced their spending.

Deutsche Bank Macro Strategist Oliver Harvey predicts that the combination of unprecedented government stimulus packages, retreating globalisation, the increase in bargaining power of certain sectors of the labour market as well as the need to reduce large debt burdens will bring about the return of inflation.

In his Konzept article, The case for inflation (page 18) he makes the point that while European government attempts to keep household incomes stable with job retention schemes , although they “have the best of intentions”, will simply result in “more money chasing after significantly fewer goods and services”. To put it bluntly, he adds, “The government is handing out US$100 bills when there is nowhere open to spend them”.

The Economist (18 April) concurs: “Worries about soaring prices start with the observation that virus-fighting measures choke off production. Crudely put, inflation is the result of too much money chasing too few goods. At present the amount of goods and services available for purchase is tumbling. Many service industries are shut down. The virus is playing havoc with the supply of some products.”²

The other problem is that a number of industries will be less profitable once some form of ongoing social distancing regulation limits the capacity at which they are allowed to operate. Examples are restaurants and airlines – which given the low-margin nature of their business models – means they rely respectively on high volumes of table bookings and flight turnarounds to be profitable – therefore the prices charged by such entities still in business would most probably rise. “If you assume 80% of restaurants cannot supply at, say, 60% capacity, do you think the price of a restaurant meal will go up or down?” asked Harvey on a recent Podzept podcast.³

As for all those precautionary savings, households’ spending and saving behaviour is – as every economist knows, says Harvey – “about expectations”. He predicts “as soon as households perceive the price of everyday goods and services starting to rise, their rainy day funds will quickly be raided to buy them.”

Another indicator that inflation is on its way back is, he adds, deglobalisation. The effects of globalisation on suppressing inflation were:

• Cross-border immigration and the offshoring of production increased the global labour supply, putting downward pressure on workers’ wages, particularly among the lower-skilled
• Enhanced competition in the manufacturing sector led to a decline in the cost of many consumer products.

The perception that high inflation is just around the corner is out there – a Deutsche Bank Data Innovation group (dbDIG) survey found that a majority of the Bank’s clients expect the pandemic to be ultimately inflationary. However, the drop in aggregate demand, says Torsten Sløk, Chief Economist, Deutsche Bank Securities, suggests that “we will not see inflation anytime soon”.

While this might be a comfort for some investors, what is the prospect of deflation, Japan-style?

"The government is handing out US$100 bills when there is nowhere open to spend them"
Oliver Harvey, Macro Strategist, Deutsche Bank Research

The short answer is that it depends on one’s perspective.

In its Economic Letter (May 2020), the Federal Reserve Bank of San Francisco examines the risk of “a significant drop in inflation from its current level” and assesses the odds using yield curve models of nominal and real government bond yields from: Canada, France, Japan, and the United States.

Its analysts conclude: “Analysis of the forward-looking information in nominal and real government bond yields shows that the perceived risk of an outright decline in the price level, or deflation, over the next 12 months has barely changed in the four countries we examine.

“Furthermore, the premium investors attach to deflationary outcomes has seen at most only a modest uptick, except for in Japan, where this premium was already elevated thanks to its near-zero inflation. Overall, these results suggest that the perceived risks of a substantial decline in inflation are limited in the near term despite the economic standstill caused by the coronavirus.”⁴

During his discussion with Oliver Harvey on the Podzept podcast, Deutsche Bank FX Strategist Robin Winkler says that “it all boils down to how quickly demand bounces back once we come out of this crisis and I am not optimistic.” He explains that what academics have learned from pandemics over the past 800 years is that people put a premium on having a “rainy day fund” after the event – something that is being underlined by current consumer surveys.⁵ See Figure 3.

Although this article has concentrated on inflation and deflation scenarios, other drivers – also discussed in Konzept – will shape the world’s climb out of Covid-19. These include what happens to global value chains now, as The Economist puts it on 14 May (Has Covid-19 killed globalisation?) “Governments and central banks are asking taxpayers to underwrite huge national firms through their stimulus packages” and “the push to bring supply chains back home in the name of resilience is accelerating”.

Covid-19 has launched an economic shock the like of which the world has never seen before – but the world is also better equipped to deal with it, note analysts. In his introduction to Konzept, Deutsche Bank’s Global Head of Fundamental Credit, Strategy and Thematic Research Jim Reid asks whether the monetary and fiscal intervention to make debt sustainable “creates a medium-term dilemma about whether it stifles creative destruction”.

The analysts comment that although “this is a trend that will continue”, there are forces at work that will still allow creative destruction to happen “without resorting to the economic malaise that sometimes accompanies it”.

In other words, the new normal will be somewhere between the extremes of Zimbabwe (galloping inflation) or Japan (deflation). It just depends on which balm economies apply to the pandemic scar tissue as to where on the spectrum between the two extremes that might be.

• The biggest bailouts in history, 20 April 2020, by Jim Reid, Nick Burns and Craig Nicol
• Konzept # 18: Life after covid-19 (pages 18 to 23, 14 May 2020) Deutsche Bank Thematic Research
• Global Macro Outlook: Slow recovery ahead (19 May 2020) by Torsten Sløk,
• Podzept: Is Covid-19 Inflationary or deflationary (13 May 2020) with Jim Reid (Moderator), Oliver Harvey and Robin Winkler

Sources

¹ See https://bit.ly/2Zne5hs at deutschewealth.com
² See https://econ.st/2LLR0Nb at economist.com
³ See https://bit.ly/3cNLgyD at dbresearch.com
⁴ See https://bit.ly/36dXw92 at frbsf.org
⁵See https://bit.ly/3bNRT2n at frbsf.org