How to deal with an inflation overshoot in major developed nations

An inflation overshoot in major developed nations, particularly the US, spills over to emerging nations through currency weakness against the dollar. This is what investors must pay attention to.

It is unlikely that the US, for instance, could see 10%-plus PCE prices as in the 70’s or the UK see the Retail Price Index (RPI) above 25%. But inflation might not need to rise anything like as high as the 1970s to cause significant economic difficulties.

Comparisons with the 1970s don’t just relate to some of the political issues we have seen recently, like the US’s rapid pull-out from Afghanistan mimicking the retreat from Vietnam in the middle of the 1970s. Mr. Steve Barrow, Head of Standard Bank G10 Strategy does think that there are some economic similarities that may be concerning to policymakers and the market. The most obvious ones, perhaps, compare the adverse supply shock of the two oil price surges in the 1970s with the supply shock that is Covid-19. He thinks a more significant comparison lies in the surge in monetary growth. In the 1970s, for instance, the end of the dollar’s link to gold saw monetary growth surge – as did the price of gold. Fast-forward to today and money supply growth has surged anew.

In fact, it’s been pretty buoyant for some time, lifted first by the monetary response to the global financial crisis. Once again, this period has seen the gold price surge. The surge in inflation in the 70s occurred in the midst of this monetary surge and some fear that a similar pandemic-related surge now will lift inflation materially as well. But those that deny there’s any inflation risk now can cite a multitude of reasons why things are very different to the 1970s. Reduced isation, lower oil-price dependency, central bank independence, forty years of low inflation (since the 1980s) that’s lowered inflation expectations, and much more have been cited as making things very different to the 1970s. These are all correct but the point we’d make is that we don’t need to see inflation go up to anything like the levels we saw in the 1970s to make the situation very difficult.

We certainly don’t expect a return to 1970s levels of inflation. But there could be big problems even if inflation only stays moderately higher than central bank targets, say at 4 or 5 percent for a period of time. The first is the de-anchoring of inflation expectations. Central banks have worked hard to stabilise expectations around their targets (which are often 2%). To lose the anchor now would risk creating all sorts of economic hardships to get them back. This leads on to interest rates, for we all know that the extensive period of very low rates, and negative rates in many cases, has potentially created all sorts of financial stability risks.

One is that low rates of return have vastly inflated the demand – and values – of other assets, like equities and these assets could implode as inflation overshoots and central banks respond. Another is that debt financing costs for governments have been falling even through their budgets have been rising fast. Even modest policy rate hikes to nip inflation in the bud, could run foul of some government bond markets and force crisis situations. And then there is the spillover to emerging market nations given the possibility that an inflation overshoot in major developed nations, particularly the US, spills over to emerging nations through currency weakness against the dollar.

All these risks, and more, stem from overshooting inflation. The key issue that policymakers, traders and investors have to ask themselves is, what constitutes an overshoot? Mr. Steve Barrow said that there would not be a return to 70s style inflation, but even something far short of that could still be very problematic given how well inflation has been wrapped up in the past and the sorts of financial market implications that this has had. Until we can be reasonably certain that the rise in inflation will be as temporary as policymakers suggest we’d be cautious of assets from bonds to equities and would tend to favour ‘safe’ currencies over riskier ones.