Should we fear that inflation will rise as demand recovers when the lockdown is lifted? As equity investors, the answer is clear: no. We should not fear inflation, but rather hope for at least a little of it.
My chart shows why. It shows that since 2008 there has been a clear correlation between share prices and inflation expectations, as measured by the gap between conventional and index-linked gilt yields (also known as breakeven inflation). Falls in inflation expectations in 2008, 2012, 2015 and recently were all accompanied by falls in equities, while rising inflation expectations in 2009, 2013 and 2016 all saw shares rise.
The UK is not alone in this respect. Francois Gourio and Phuong Ngo, two economists at the Chicago Fed, point out in a recent paper that the US has seen the same pattern.
In both countries, this represents a total U-turn from previous years. For a long time, inflation was terrible for equities. The surge in it in the 1970s was accompanied by a slump in share prices, while the long decline in inflation in the 1980s saw a great bull market. And even in the late 1990s, falling inflation expectations were accompanied by rising equity prices.
So what changed? To see it, think back to the 1980s and 1990s. Higher inflation then was bad for shares on two counts. First, it led to fears that the Fed and Bank of England would raise interest rates. That hurt shares not just by raising the attractiveness of cash but also by fuelling fears of weaker growth in earnings. Secondly, inflation created uncertainty: how high would it go? Would central bankers’ efforts to combat it plunge economies into recession?
When interest rates are near zero, however – as they have been since 2009 – this logic is flipped on its head. Now, it is deflation that is the big fear. It would raise real interest rates (as inflation turns negative but rates stay around zero) and create uncertainty, in part because aggregate deflation in the west is so unfamiliar.
The problem here is not that central banks can do little to support economic activity when rates are zero and the aggregate price level is falling. They can do plenty: not just quantitative easing but subsidies to banks to lend (such as the ECB’s targeted long-term refinancing operations), direct financing of government borrowing, or simply depositing money into everybody’s bank account.
Instead, the danger is corporate debt. Companies that see their prices fall while interest rates on their debt stay above zero will find it harder to service their debts. That threatens a wave of bankruptcies and hence losses for banks, causing them to withdraw credit from even healthy companies. In this way, price deflation can cause debt deflation. And as we’ve learned from the aftermath of 2008, financial crises can depress economic growth even in the long run, to the detriment of corporate earnings.
Of course, this is only a risk. But it’s one that increases as inflation falls. And it’s perfectly reasonable for investors to worry about the small but rising chance of something nasty.
But will the risk materialise? For now, investors believe it is only a small danger: although breakeven inflation has fallen, it is only around a four-year low. This is because while there is a danger of a weak recovery in demand which might depress inflation, other factors might keep it up. The fear of catching or spreading the virus might keep people at home even when the lockdown is legally lifted; the lockdown will create a wave of business failures that will reduce capacity and so raise inflation; and the crisis is creating a mismatch between the pattern of supply and demand, which could itself raise inflation.
We cannot, however, be at all certain about any of this. We are in uncharted waters. What is plausible, though, is that the risk of deflation – small as it is – is weighing down share prices and so a rise in inflation would be a good thing to the extent that it reduces this risk. Some of the ideas we picked up in the 1970s and 1980s are wrong.
