After pandemic comes high inflation, but how long is the lag? The currency markets hold the key and huge swings now lie ahead there. A collapse in a nation’s currency sets its inflation rate on fire. COVID-19 has jammed the safety valves by wreaking destruction on the supply side of economies and setting governments on the path of bankruptcy.
The outbreak of disease administered a massive supply shock in the sense of a wide span of services and workplaces no longer being free of infection. Once the pandemic is over, that supply shock fades – infection free services become available again widely – but large areas of capital stock will have meanwhile suffered erosion.
Much of the capital stock paralysed during the health emergency, whether in the bricks and mortar related sectors or wider afield including travel, will turn out to be economically obsolete; enterprises and entrepreneurs who might have salvaged some of this have been decimated by financial collapse. In turn the pandemic, accompanied by powerful monetary inflation, stimulated over-investment in some areas. This turns out to be non-economic when it its aftermath, demand shifts at least partly back to its normal pattern (think here of an over-extension of online retailing and stay at home technologies including cloud computing).
Meanwhile on the demand side of economies pent-up energy is developing. Households which have been forced to curtail spending by infection risk have in some degree switched some of their consumption to the infection-free parts of the economy (including furniture and home improvement for example). They intend to disburse their added savings once the pandemic is over. Governments have compensated households and businesses hit worst by supply shock. They have plenty of scope to use their central banks to raise taxation whether from monetary repression (keeping interest rates abnormally low) or from inflation tax.
Once upon a time the chart of money printing by central banks would have produced a direct clue as to the timing of inflation. But in today’s world where monetary systems have become essentially unanchored and so-called high-powered money has lost its unique attributes there is no such connection. What has not changed, though, is the power of the exchange rate to trigger high inflation. Great inflations, and indeed hyperinflations, have all in varying degrees been led by the currency collapsing first.
As of now, bond markets are highlighting a greater likelihood of high inflation in the US than in Europe or Asia, with forward-forward 5-year inflation rates (derived from the difference between yields on inflation-protected and non-protected bonds) 100bp higher in the US, say, than in euro-zone. We should treat those estimates with a grain of salt. Technically, the inflation indexed markets are so narrow in Europe, that the forward-forward rates may be distorted downwards by liquidity premiums.
The pick-up of US inflation following the pandemic could be led by a sharp fall of the dollar. But that is an implausible scenario. Public finances there have not approached the critical levels of degradation seen in some large European countries or Japan and the apparent continuing Republican majority in the Senate should keep the lid on “fiscal stimulus”. Global capital inflows are likely to play a key role in financing the recapitalization of the US economy after the destruction of the pandemic, relieving any shortage of savings for that purpose.
By contrast, consider the currency collapse possibilities in Europe and China. In the case of the euro-zone we should reckon with fact that ECB balance sheet is full of weak assets which could not be sold – so there is no way back to normality unlike for the US where the Fed’s balance sheet can be readily slimmed. The most likely trigger to euro collapse is concern about Germany’s willingness in extreme conditions to go along with “whatever it takes” to save the “common currency”and the naked fact that the epicentre of any global credit darkening would be European banks and sovereigns.
The pound’s candidature as a currency in collapse stems from the intensity of the damage which the UK economy is suffering from the pandemic. Its huge London metropolitan area has been struck not just by the supply shock to its international business hub but also by the reality of a Brexit deal which strips its vital service sector, especially the financial industry, from free access to the EU market. Sterling devaluation is an obvious stimulus tool left to the growingly unpopular Johnson government.
Turning to China, Beijing can bail out effectively bankrupt banks and other financial institutions, but in consequence its public debt GDP ratio would rise in excess of 400 per cent of GDP. We should doubt the willingness of foreign creditors of Chinese entities to roll over their positions and certainly the Federal Reserve would not offer them any back stop in the form of dollar swap lines to the People’s Bank. High inflation and currency depreciation might be the only way out.
Yes, pandemic has unleashed a race to the bottom amongst the fiat monies. In typically short-sighted currency market there may not be money to be made at this stage from speculating who is the final winner of the race. But there could be large gains from getting the interim winners right.