Is inflation returning ?


After thirty years of disinflation, and in the face of massive injections of liquidity by central banks, are we on the verge of a resurgence of inflation?

The current crisis is exceptional in many ways, not least because of the magnitude and velocity of the economic shock we are facing. The economic policy response has also been unprecedented, with massive intervention by governments and central banks. If low interest rates lend credence to the sustainability of government debt, what about inflation? After thirty years of continuous decline, are we now at the dawn of a change in the inflation regime?

The current period is marked, from an economic policy point of view, by major intervention by States and central banks. In barely two months, the Federal Reserve (Fed) and the European Central Bank have announced more support measures than in the 18 months following the subprime crisis in 2008. The monetary stimulus is major and is matched only by the fiscal stimulus of the States. The economists' consensus forecasts a budget deficit of more than 20% of GDP in the United States and nearly 13% in the Euro zone. Among the developed countries, Japan is not to be outdone, with a recovery plan of nearly 20% of GDP. Such an alignment of monetary and fiscal policies has never been implemented in the last ten years. The hypothesis of currency neutrality, dear to the monetarists, teaches us that inflation is largely a monetary phenomenon and that the financing of public deficits by central banks leads to a general rise in prices.  Nevertheless, this hypothesis is largely refuted by the weak price dynamics of the last ten years. Thus, a combination of a sharp increase in public debt and the growth of central bank balance sheets has been observed. But credit dynamics must also be taken into account: the subprime financial crisis led to a contraction and then a rationing of the credit supply. Weak demand naturally led to a moderation in the price of goods and services. 

Since the outbreak of the Covid-19 crisis, households have sharply increased their savings rate, partly because consumption was prevented during the period of containment. On the other hand, and this is quite reassuring, the growth of credit to the economy has been particularly dynamic, despite very poor visibility on activity. These trends have yet to be confirmed but are a sign of the renewed health of financial institutions. 

But inflation is not just a monetary phenomenon. It is clear that other highly deflationary factors at work over the last thirty years were already coming to an end. The doctrine of free trade and its achievements in terms of growth and purchasing power were the victims of Brexit and the end of multilateralism advocated by the Trump administration. The downward trend in customs duties gave way to a doctrine of national preference in the Anglo-Saxon countries.  The current health crisis raises the debate on the dimensioning of sovereignty, particularly in terms of essential goods and services, and argues for the relocation of part of the production chains. Technology, for its part, remains a driving force for productivity gains, but the subject of the distribution of wealth with the development of a bipolar economy argues for a rebalancing and stronger regulation of the labour market, particularly with regard to service platforms. 

The last decade has also taught us a lot about the valuation of financial assets. Indeed, there is a strong correlation between the balance sheet growth of central banks, and the Fed in particular, and market performance. Despite weak demand for credit from households, which have continued to deleverage, and largely sluggish nominal growth, the performance of equity markets has largely contradicted the most pessimistic forecasts. It is as if the excess supply of money was spilling over into the financial asset market in a fairly stable and predictable manner. While there has been no rebound in inflation in the prices of goods and services, there is clearly inflation in the prices of tangible assets.

There is some similarity in the current period, and it is reasonable to anticipate that money creation, resulting from the financing of public deficits by central banks, may lead to an increase in real asset prices. On the foreign exchange market, in an open exchange rate system, monetary creation should weigh on the value of currencies, but it is clear that all countries are confronted to varying degrees with the same challenges. Gold and precious metals, whose reserves remain fixed, are expected to appreciate by the same amount. More generally, high-quality real assets, within real estate and equity markets, which have the capacity to build up a reserve of value, should continue to be sought after and should play a key role in asset allocations.

In the short term, the decline in activity is such that any prospect of a resurgence of inflation is illusory. On the other hand, if the upturn in activity continues, the rebalancing in favour of a more sustained price dynamic should begin and allow the effectiveness of economic policy to improve. But the amounts of money creation are unquestionably staggering, and already, household expectations are already incorporating the prospect of higher prices. The effects of these support measures on the value of assets will be decisive in defining an asset allocation that is necessarily prudent but sufficiently robust to adapt to new equilibria.

Chief Investment Officer Société Générale Private Wealth Management