Inflation isn’t gone for good amid Covid-19

After the world has finally worked its way beyond the Covid-19 crisis, it may have to confront a danger that almost everybody has forgotten: higher inflation. At the moment, it’s the last thing investors and governments are worried about, which is exactly what makes the threat so plausible.
It has been decades since governments have lost sleep over high inflation. Especially since the Great Recession of 2008, their biggest anxiety has been just the opposite: Central banks have struggled to raise inflation to their target rates, and with interest rates stuck for years at the so-called effective lower bound (zero or a bit less), they’ve worried mainly about the risk of deflation.
That’s the thinking currently priced into financial markets. There’s no trace of higher inflation in any of the standard measures of expectations. And on the face of it, this makes sense. Covid-19 has delivered a strong deflationary shock to the system. Demand has cratered, despite strong fiscal stimulus and further recourse to unorthodox monetary measures. Yes, supply has crashed too, but the net effect so far appears to have been an even bigger shortfall than before of demand relative to supply— which is what “deflationary shock” means.
At some point, though, this could change. Suppose Covid-19 causes significant and persistent long-term damage to worldwide production and supply chains. And suppose governments and central banks continue to fuel demand in an effort to support living standards as though that fall in potential output hadn’t happened. In that case, you’d expect inflation to rise. This thought complicates matters for risk-averse investors perturbed by the buoyancy of stock markets. Assets such as equities are a hedge against higher inflation (earnings go up when prices rise). Investors in medium- or long-term bonds, on the other hand, are very much at risk if inflation accelerates. Cash isn’t so safe, either, once higher inflation starts eating away at its purchasing power. This is unlikely to be a concern in the next few months or quarters. For now, unstinting monetary and fiscal support is surely necessary. But the subsequent unwinding of these measures won’t be straightforward, and that’s when the risk of higher inflation might emerge.
For one thing, levels of public debt are certain to be much higher, and in due course attention will turn to the steps needed to contain them. At that point, economies could still be a long way from full employment, because the post-coronavirus adjustment is likely to involve some restructuring of the economy, as opposed to merely rehiring people into their old jobs. Against that background, there’ll be resistance to renewed “austerity” — meaning tax increases and cuts in public spending. Yet without deliberate fiscal tightening, governments could find it harder to persuade investors to keep buying their debt, which in turn would push bond prices down and interest rates up.

—Bloomberg