Good vs Bad Inflation
Commentary
US 5Y forward 5Y inflation swap rate, a measure of expected inflation (on average) over the five-year period that begins five years from today, hit 1.9% last week. This is quite a turnaround from the bottom of 1.2% reached on March 20, when global markets were under considerable stress with the Covid-19 pandemic spreading swiftly. Inflation expectations in the UK and Euro Area have also displayed similar trajectory in recent months.
The upshot of a rise in inflation expectation is a concomitant decline in real interest rates. US 10-year government bond has seen a decline in nominal terms in recent months; combine that with a rise in inflation expectations, real 10-year yield is now hovering around a low of negative 1 percent. Despite all the lingering uncertainties about the outlook, such low rates, as one would expect, have helped the market for residential mortgages, improved corporate sector debt service capacity, pushed down the USD, and eased overall financial conditions.
A world beset with low growth and high debt burdens could do with a healthy dose of inflation. The thrust of G3 monetary policy over the past dozen years has been to mitigate deflationary risks. After pricing in a resurgence in such risks in March, markets have responded favourably to the seismic easing measures put in place since then. So, could some inflation be around the corner?
Not all inflation is the same—there is “good” and “bad” inflation. Good inflation could come from successful monetary policy action. If interest rate cuts and liquidity injections push up bond prices, it would signal demand for debt. That could perk up the credit channel. As the higher borrowing translates into an increase in consumption and investments, there ought to be a rise in prices.
Good inflation can also come from successful public investment. Properly targeted investment in infrastructure, jobs training, and technology promotion can boost employment and productivity, which in turn push up returns on capital, workers’ wages, and consumer demand. If some of the large-scale public sector deficits being run presently by the fiscal authorities worldwide are directed toward green initiatives and filling investment gaps in transportation, communication, health, and education, some good quality growth and inflation would be in the horizon.
In contrast, bad inflation can come from supply shocks. Lately, prices of some products (e.g. processed foods, cleaning material, protective gear) have jumped owing to pandemic-led demand spurt and supply shortages. Bad inflation can also stem from poor policy, ranging from protectionism to nationalism that reduce competition and introduce a wide range of distortions in the production process and supply chain.
Markets are pricing in a slight rise in inflation expectations, but is it the good or bad kind? We are afraid there isn’t much in the pipeline that makes us optimistic about better growth, demand, and higher wages, which in turn could cause good inflation. There are however plenty of drivers of bad inflation. If the world has to live with physical distancing while using protective gear for years to come, prices of restaurant meals, hotel stays, and air travel are bound to go up. This would be taking place amidst massive liquidity injection and frothy asset prices, adding fuel to the dynamic that sees prices go up. Several years of pandemic will also cause bankruptcies, constraining supply. Pessimistic investors could hold off investments, further scaling back capacity. Watch out for such markers.