Walter Molano | Deflate or inflate
Published:Friday | June 12, 2020 | 12:17 AM
OP-ED CONTRIBUTION: EMERGING MARKET ADVISER
There is widespread thought that the effects of COVID-19 will be deflationary. Indeed, the latest inflation numbers have confirmed a sharp drop in consumer prices.
The headline inflation rate in the United States plunged 0.8 per cent year-over-year in April, the lowest level since the financial crisis of 2008. Gasolene prices fell 20.6 per cent y/y, due to the ongoing chaos in the international oil markets.
The collapse in economic activity explains the low inflation rate. Consumer demand evaporated, as people were ordered to shelter in place. Restaurants closed. Vacations were put on hold, and all social activity was reduced to a minimum.
It is not surprising that producers lost all pricing power, and many resorted to deep discounting to move remaining inventories.
This situation was repeated across most of the global economy, with the exception of Argentina. Consumer prices continue to rise as the Argentine peso devalues, due to concerns about the restructuring of the sovereign debt and the economic effects of the ongoing pandemic.
The Argentine producer has a dollarised mindset, and any change in the exchange rate is immediately translated to changes in consumer prices. As of March, Argentina had the dubious distinction of having the fourth-highest inflation rate in the world, preceded by Venezuela, Zimbabwe and Sudan — a peer group that most Argentines would be loathe to join.
Still, economists expect that the deflationary pressures will persist even as the global economy recovers. The immense amount of slack produced by the downturn will take a long time to work out, and many producers will discount prices to lure consumers back into the marketplace.
However, does this mean inflation is dead? If history is any guide, probably not.
The Black Plague (1348-1350) left an indelible mark on Europe. An estimated third of the population succumbed to the pandemic, producing important social, economic and political effects.
Up to that moment, European society was organised around the manor — a self-sufficient, agricultural unit that bonded peasants in permanent servitude to a manorial lord. There was no social mobility, and there was virtually no commerce. A few trade guilds were allowed to operate, providing the manors with specialised services.
Unfortunately, the Black Death became known as the great leveller, as it wreaked havoc on the entire population — the aristocracy, the peasantry and journeymen alike. Entire manors were wiped out, and the surviving lords offered better terms to the wandering bands of peasants to lure them back to work.
By the start of the 15th century, as the effects of the pandemic receded, wages began to rise, as peasants demanded more pay, and inflation took off.
Today, the situation is not exactly the same. COVID-19 is extremely contagious, but fortunately, its lethality is relatively low. Therefore, the number of deaths pale in comparison to the Black Death, but the policies put in place to combat the spread of the diseases may trigger new supply-side inflationary forces.
Social distancing will become the new normal for the foreseeable future. This will have important consequences for producers of goods and services.
The rates of production or the economies of scale that were required to produce profits, with low prices, will be gone. The pace of production lines will need to slow to accommodate social distancing between workers. The maximum capacity of service providers, from airlines to theatres to stadiums to restaurants, will need to be reduced. Added sanitation procedures and control personnel will raise operating costs.
As a result, producers will need to pass the increase in costs to consumers. The result will be an unexpected change in the inflation rate. Indeed, history has shown that inflation typically rises after pandemics. This is usually due to the decline in the size of the workforce.
However, this time the driver may be the increase in costs and a decline in revenue, due to new precautionary procedures. The question this creates is whether this is one of the reasons why the markets continue to rally, despite the continuous stream of negative economic news. It’s true that investors were buoyed by last Friday’s decline in the unemployment rate. Nevertheless, an unemployment rate of 13 per cent is no reason to celebrate. Instead, what we could be seeing is a move to pick up real assets, in anticipation of a rise in the inflation rate.
Such a move could be dangerous for other reasons. A rise in the inflation rate could lead to a sudden reversal in global monetary policy, thus producing devastation across much of the financial world. It is still too early to tell, but it could be a logical explanation for the illogical spike in equity prices.
Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.