The inflationary debate

In my article last week, I provided an overview of the developments related to the market frenzy over GameStop Corporation and other companies that were until recently very much ‘out-of-favour’ following numerous ‘short squeeze’ attempts by several investors sparked by a social media platform. This was one of the most widely discussed topics across international financial markets since the start of 2021.

Another widely-debated topic in recent weeks has been on whether inflation is likely to make a comeback in the months and years ahead. Inflation across major economies has been low for the past several years following the 2008/09 global financial crisis. The main argument is whether inflation will spike as a result of the pent-up demand across a number of sectors as well as the massive interventions by central banks and governments following the severe economic recession caused by COVID-19.

In essence, there are three main types of inflation: monetary inflation, asset price inflation, and consumer price inflation. Monetary inflation reflects the total amount of money in circulation and is mostly driven by the physical cash printing activity conducted by central banks, the lending activity of commercial banks, as well as the fiscal policies adopted by governments. In this respect, reference is often made to the size of central banks’ balance sheets which in recent years expanded significantly following the enormous amount of new money created through various quantitative easing programmes. In fact, the estimated amount of total assets held by the world’s four major central banks – namely the Federal Reserve, the European Central Bank, the Bank of Japan, and the People’s Bank of China – surged from around USD7 trillion in 2008 to almost USD30 trillion.

Monetary inflation is usually the trigger leading to asset price inflation and consumer price inflation. Asset price inflation reflects the increase in the prices and valuations of assets, from the more traditional type of securities such as shares and bonds, to other assets like land and real estate, commodities and precious metals, as well as collectibles and antiques. On the other hand, consumer price inflation relates to the changes in the prices of goods and services that are of essence for one’s living. Consumer price inflation is one of the main mandates of central banks who seek to maintain price stability. For the Federal Reserve and the European Central Bank, this translates into an inflation rate objective of close to but below the 2% level.

Given the enormous monetary inflation which took place over the past twelve years following the global financial crisis, many economists and financial analysts have often debated at length about the low level of inflation. At the same time, however, asset price inflation shot up drastically as seen by the performances and returns generated by some of the major equity indices across the world. Several commentators have also often questioned whether the so-called ‘Phillips Curve’ is still valid and effective today given the apparent breakdown of the inverse relationship between employment and inflation. The ‘Phillips Curve’ observes that increased levels of employment in an economy leads to higher consumer price inflation, and vice-versa.

COVID-19 and the unprecedented amount of monetary and fiscal stimulus that was quickly unleashed by central banks and governments in response to the pandemic have triggered the return of the fear that consumer price inflation could spiral out of hand if left uncontrolled. This concern must also be viewed in the context of the expected release of pent-up economic activity as the recovery starts to unwind and gain further traction in line with the progress being registered in the vaccination of a large part of the world’s population.

Moreover, there have been clear indications in recent months by both the Federal Reserve and the European Central Bank that they are ready to accept consumer price inflation to overshoot their targeted level with a view of ‘compensating’ for the prolonged periods were consumer price inflation fell short of the level mandated.

In contrast, some sceptics argue that the powerful forces that kept a lid on consumer price inflation following the 2008/09 global financial crisis not only continue to be effective today but are also expected to persist, if not strengthen, further in the years ahead. Deeper integration and globalisation of the world economy (especially following the election of Joe Biden as President of the US), the huge impact of technological disruption which advanced rapidly following the onset of the pandemic, ageing populations particularly in developed economies, as well as the wide implications of outsized debt across many countries, companies and individuals make it very difficult for consumer price inflation to return to the more normal levels seen prior to 2008.

The effects that consumer price inflation have on the prices of different asset classes vary widely. In general, higher consumer price inflation is very detrimental to the prices of non-inflation-protected bonds. This has been very much in evidence lately whereby, for example, prices of Malta Government Stocks trended markedly lower after the release of encouraging signs in annual consumer price inflation in the euro area which reached an eleven-month high of 0.9% in January 2021 compared to -0.3% in December 2020. This is due to the fact that higher inflation would tend to lead to an increase in interest rates by central banks, thus contributing to the erosion of the present value of future cashflows which are fixed in nature. Similarly, in the US, the 10-year Treasury yield is now at around the 1.2% level compared to just over 0.3% in mid-March 2020 during the height of the COVID-19 panic across international financial markets. The higher benchmark rate is a cause for concern for bond investors following the multi-year bull market in bond prices and a signal that the market anticipates higher inflation ahead.

On the other hand, the effects of higher inflation on equity prices do not follow a straightforward pattern. Inflation that is kept well under control is generally considered to be positive for the performance of share prices as this would imply healthy and sustainable levels of economic growth. On the contrary, anaemic inflation is synonymous with a fragile economy which, in turn, has negative implications on cash flows, growth and risk – the three key components which are critical in any corporate valuation.

With the federal funds rate in the US and the deposit facility rate in the euro area expected to remain at their current record low levels for the foreseeable future, coupled with the intentions of both the Federal Reserve and the European Central Bank to maintain an accommodative stance towards quantitative easing, it is widely believed that inflation will be a recurring theme across international financial markets in the coming months and possibly years. In this context, it is imperative for the various types of investors to be as diversified as possible while maintaining a flexible approach to investing in line with the fast-changing dynamics of the world economy, the underlying strength of the recovery, as well as the shape of the new economic world post-COVID-19.

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