The pernicious impact of inflation on savings during the 1970s will be within the living memory of many people. Today we find ourselves in an environment where there are real concerns of a return to rampant inflation, given the recent flood of money that has been pumped into the system. Governments around the world have spent huge sums combatting the effects of Covid-19. According to the ONS, the UK government alone had spent some £270 billion in this battle, up to December 2020, equating to around £4,000 per person. This money has, for the most part, been funded by borrowing and the Government’s deficit has ballooned to the equivalent of 20% of GDP, something which is almost without precedent outside wartime.
Central banks globally have stepped in to provide governments with the financing that they have required, resulting in vast waves of liquidity entering the system. These QE programmes have comfortably surpassed the sums that were injected into the system following the great financial crisis of 2008/2009. Another important difference is that today this money has gone directly into people’s pockets; 10 years ago, it was used to prop up the banking system with banks using this liquidity to restore their balance sheets. In the UK and in Europe, this cash injection has principally taken the form of furlough schemes. This has been an incredibly expensive exercise by which governments have paid large swathes of the workforce to be inactive while their employers have shuttered their operations. The US Government has taken a slightly different approach preferring to send cheques to the vast majority of adults. Last year, Donald Trump sent each qualifying individual $1,800; Joe Biden is now working on a further package which could distribute another payment of $1,400 to a large proportion of the adult population. This is essentially helicopter money designed to support the economy and combat the deflationary impact of Covid-19.
A consequence of all this fiscal action is an increase in monetary supply, the likes of which we have not seen for some 20 or 30 years. This, according to economic theory, could result in inflation. However, there is a competing economic theorem adopted by various deflationists who argue that all this debt generation in itself reinforces disinflationary trends within the economy. This is best illustrated by an example. If you are considering buying a car, you have two options. You can either put money aside for two or three years and buy the car when you have saved enough. Alternatively, you could borrow money and buy the car today. By borrowing money, you create demand today; if you delay the purchase for three years, so too is that demand delayed. In the real world, we have seen a continual build up in debt over the last 20 or 30 years, bringing demand forward to the present day. Of course, when tomorrow comes, there will be a demand deficiency. As a result, central banks and policy makers are continually having to stimulate the economy to generate the necessary demand.
It is not yet clear which of these two theories will win out. We do expect inflation to revive as economies emerge from lockdown and it may well rise above the Bank of England’s two per cent target zone. Indeed, a steady, stable modest level of inflation would be beneficial for the overall economy as it will help to address some of the current debt imbalances. However, while we do not foresee a significant spike in inflation and any rise is likely to be temporary, there is always the potential threat that inflation will continue to accelerate to quite concerning levels. This could have more severe consequences that financial markets currently do not anticipate, leading to significant dislocations. It is therefore important to continue to monitor how events unfold over the coming quarters.