September 19, 2020

The mirror of the de-escalation



The resounding response of governments and central banks to the coronavirus crisis has reopened the debate on the consequences that unappealable, in quantity, public stimulus programs worldwide could end up having on the price level of the economies. In the same way that with the de-escalated hack of confinement, from more to less, three phases could be identified onwards, but in the opposite direction, from less to more, in the expected dynamics for prices: a first one, where the disinflationary pressure would dominate in the short term; a second, in which the end of the restrictions and the recovery of the price of raw materials would favor a period of reflation, which would last until the end of next year; and a third, when inflation could exceed central banks’ targets, but would not reach worrying levels.

After phase 1, phase 2 could usher in a more effective price recovery. This process would be driven by a certain reduction in the production gap, a moderate recovery in the labor market and a possible additional twist in terms of deglobalization, foreseeable in the early stages after the pandemic, which, accompanied by a rise in the price of raw materials, would give rise to a process of reflation. This second phase, a bridge between the kind of depression associated with the complete paralysis of the economy in the first half of 2020 and the recovery of the pre-crisis price level, could extend until the fourth quarter of 2021. From that moment, the threat of a high inflation rate would become more important. The reason is that Both the fiscal and monetary responses have now been much stronger and faster than those exercised during the Great Financial Crisis. (GCF). A particularly vigilant factor is that the broad money supply (M2) in the US has grown significantly in recent months. And it is perfectly arguable that a combination of restricted productive supply with rapid monetary growth may precede an upturn in inflation. The key lies in how much of this monetary expansion ends up being spent effectively, which is understood by money circulation speed. For such an upturn in inflation to occur, it would have to be accompanied by an acceleration in the speed of circulation, which, for reasons such as precautionary savings by households or the lower expected investment by companies, could even fall. But unlike what happened after the GCF, This time the money will go to households, especially those with less resources which, in turn, have a higher propensity to consume, which would cause the price level to rise. AND in this crisis what is most at risk is the productive fabric formed by SMEs for which, thanks in part to the stronger muscle in the financial sector, greater stimulus penetration would be achieved.

Therefore, it is in phase 3, approximately from 2022, when the central banks would have to face greater risks for price stability. It will be crucial to keep the balance between not lifting stimuli too early and not overheating the economy too much.. It is reasonable to think that the total recovery of the economy will end up prevailing over the strict control of prices, and, therefore, the monetary authorities will eventually be more tolerant of inflation rates that exceed their objectives (also aware that a little more inflation would alleviate the liabilities of economic agents, whose debt will increase, in some cases substantially).

So, it is plausible that from 2022 onwards we begin to see a somewhat more significant escalation of inflation, but far from it would take us back to the extreme episodes of the last three decades of the 20th century caused by oil shocks, automatic indexing mechanisms, and unsuspecting policies in developed countries and heterodox in emerging ones. Henceforth, inflation would rebound, yes, but it would not overflow, among other factors, by still appreciable levels of idle capacity in the world economy, weakness in the wage variable, some current, albeit attenuated, sclerosis in the transmission mechanisms of monetary policy and more prevented authorities thanks, in large part, to the legacy of Paul Volcker, chairman of the Federal Reserve between 1979 and 1987, considered the “pioneer” in the fight against inflation in the modern age.

Alfonso García Yubero is Director of Strategy Santander Private Banking

Alfonso García YuberoAlfonso García Yubero


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