Inflation may not only be a short-term risk, report says

Economic forecasts have warned about the risks of short-term inflation as the global economy eventually recovers from the Covid-19 pandemic, but a report from Richardson Wealth makes the case that rising inflation could be a longer-term problem.

Several observers have highlighted the potential effects of monetary policy, elevated savings and pent-up demand pushing up prices once vaccines are distributed and lockdowns end. But many also point to how inflation failed to materialize despite central banks’ quantitative easing (QE) following the 2008 financial crisis.

In the U.S., financial institutions repaired their capital ratios after 2009 but there wasn’t demand for lending in the real economy, the Richardson Wealth report said. In Europe and Japan, fiscal austerity offset QE’s impact.

What’s different today is that central banks are buying trillions of dollars worth of bonds while governments issue record amounts of bonds to fund fiscal spending.

“As a result, a greater portion of this stimulus has gone directly into the real economy,” the report said. “This would be inflationary, but since we are in a recession, it is just offsetting much of the deflationary pressures.”

The question is the extent to which inflation returns as economies recover while central banks maintain their loose monetary policy.

A BMO report earlier this month said “inflation risks are creeping back onto the radar.” It forecast U.S. inflation would end the year at 2.5% before declining to 2.2% in 2022, pointing to unemployment remaining above pre-Covid levels and digital technologies continuing to reduce costs.

“While the risks may still be manageable, they can wreak havoc on markets, borrowers and the economy,” senior economist Sal Guatieri wrote. “At the very least, this is one ‘black swan’ policymakers and investors will need to be on a sharp lookout for in a post-pandemic pond.”

But the Richardson Wealth report pointed to some of the longer-term deflationary pressures declining.

Companies “reshoring” production to more expensive home markets could continue post-pandemic, the report said, and demographic trends are “gradually entering a less deflationary phase” as millennials start families and purchase homes and second cars.

“Deflationary pressures are not going away soon. But it does appear that many are becoming less deflationary and will continue to do so over the coming years,” the report said.

“As this long-term deflationary pressure gradually abates, to a degree, and central banks likely continue to re-imagine the new limits of monetary easing, we believe inflation will trend higher during the 2020s decade.”

This would have implications for investors. Value stocks would be more likely to outperform growth in an inflationary environment, and real assets tend to outperform financial assets, the report said.

Another challenge is that some of today’s investment strategies didn’t exist during the last inflationary period.

“Back-testing and historical performance will therefore become less useful,” the report said. “Investors will have to creatively imagine how strategies or products may perform amid any rise in inflation.”