For now, though, the greater possibility is disinfection – a reduction in inflation. The data, which included a 0.4% decline in the US Core Consumer Price Index in April, the biggest monthly fall on record, indicates what we will see next month. Vanguard hopes that, in the near term, the effects of reduced demand will outpace ward upward pressure on inflation due to unemployment and general reluctance to spend on consumers. But in the end, any long-term impact on the supply chain, a large government debt overhang, and a US Federal Reserve may be willing to tolerate somewhat higher inflation and push up prices further.
Opening the lockdown
Governments around the world are now questioning how and when their economies will reopen without a second wave of infection. The answer will tell when the economic recovery may begin, the depth from which the economy will return, and when prices will begin to move towards or above the central bank’s targets, which are usually 2% or below.
It certainly depends on the health outcome. Any progression will be stimulated by another outbreak in the case of coronavirus. It can be a two-step-forward, one-step-back method for some time. We can expect it to be like three or four steps forward before taking any step back.
Weighing against that unknown, consider these observations about the possibility of inflation in our current context:
This is not a 1970s supply shock. A number of initially Western Arab oil embargoes famously contributed to the doubling of inflation in the 1970s, as wages were higher in anticipation of higher prices. On the other hand, epidemic-related supply disruptions – some packaging operations in the United States have been shut down due to the recent Kovid-1 outbreak threat to meat supplies – are likely to affect a wide range of products but against a different background. Weak demand supply can offset the impact of declining inflation. Although inflationary pressures may occur if demand returns before supply, we cannot say for sure when consumers will be ready to spend as much as before the crisis or when suppliers will be able to resume normal activities.
The credibility of the central bank is the opposite. The central bank, particularly the Fed, has learned valuable lessons from the 1970s on how to combat high inflation and has built credibility by helping to maintain reasonable inflation expectations. The Fed’s dual order is price stability and the most sustainable employment. Most other central banks have price stability as their only order, so they will focus more on inflation.
The credibility and power of the central bank plays a big role. The aftermath of the global financial crisis has shown that central banks can protect inflation from rapid growth even during strong financial support, high debt levels and a larger central bank balance sheet. That said, as most central banks have fallen short of their targets in recent years, they will probably tolerate inflation above the target নয় not double the 1970-style inflation, but inflation is reasonably above 2%. And if it starts to break higher, they will have the ability and tools to fight (such as increasing policy rates). In recent years – and, we would expect, for the rest of this year – it has had a downside where they have struggled, as interest rates have come down to zero or below and even banks have taken drastic measures to try to bring inflation to a more reasonable level. This is another reason why we are now more concerned about sterilization rather than higher inflation.
As for the leading indicators, we will pay close attention to the price that producers have to pay for their raw materials. As these prices rise, due to increased demand or supply-chain, consumers are more likely to follow prices. The figure below considers the relationship between U.S. consumer and producer prices.
The effect of Covid-1 of is currently reducing prices
Note: The figure changes the key U.S. consumer price index – reducing consumer prices to the effect of volatile food and energy prices – related to the main component measurement (a statistical strategy that extracts a general signal from the data) of the producer price survey.
Source: Data analysis from the U.S. Bureau of Labor Statistics, as of April 30, 2020; The Federal Reserve Bank of Dallas, Philadelphia, Kansas City, Richmond and New York; And the Institute of Supply Management.
According to statistics, despite the recent COVID-19 supply-discipline problems, producer prices are falling. We expect consumer prices to follow a similar trend at least in the near term.
The last few months of global policy efforts have been unprecedented, rightly so given the unprecedented nature of the challenges facing the global economy and health officials. When the challenge is over immediately, the central bank’s balance sheet and financial budget may do something to bring things back to normal and may involve a little more inflation than the target. With more information on the recovery trajectory, we will formulate our long-term vision. But the experience of the global financial crisis shows that the fugitive inflation of the 1970s does not have to be part of it.
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