As if we didn’t have enough problems to confront, a debate is brewing about whether the world could face deflation, or inflation, when we emerge from the crisis.

There are convincing arguments on either side. But there is certainly a compelling argument for deflationary conditions persisting for at least the short to medium term, as global supplies exceed slow-to-recover consumer demand.

Why would deflation be such a big issue for the world economy?

Two events, one that is hopefully a flash in the pan and the other far more entrenched and almost impossible to turn around, highlight just how disruptive and painful deflation can be for an economy.

The first is fresh in our memory: the staggering decline in oil prices during the first few months of this year and the unprecedented descent of the WTI May futures contract into deeply negative territory, with investors willing to pay buyers to take the oil contracts off their hands.

Oil prices have recovered somewhat since then, but these price moves highlight just how difficult it is to get supply and demand in balance when the macroeconomic context is so difficult to read and the outlook so unpredictable.

Energy prices could prove a leading indicator of whether countries are set to experience deflation or inflation. If oil prices remain at their current low levels or decline back to their 20-year lows in March, economy-wide deflation could well ensure.

However, a sharp rebound in oil prices would become a key ingredient in a resurgence in inflation.

Another key determining factor will be whether the multitrillion-dollar stimulatory measures feed through to final consumer demand.

Two Schroders analysts had a face-off on whether inflation or deflation is likely to pose the biggest challenge for monetary policy authorities going forward. Abdallah Guezour, head of Emerging Market Debt and Commodities, argues in favour of inflation returning in the next two to three years. He bases his thesis on the following points:

• Unprecedented monetary and fiscal policy measures will create inflationary pressures sooner rather than later.
• Less globalisation, or even deglobalisation, could exacerbate supply shocks that already existed before the Covid-19 lockdowns.
• Any signs of normalisation in the demand for commodities would increase their prices from historically depressed levels.

In contrast, Keith Wade, chief economist, who believes the current economic shock is extremely deflationary, argues that inflation is unlikely to return for the following reasons:

• The economy is not likely to experience the quick snapback that people hoped for when the crisis started.
• As the economy begins to open up, companies will still discount aggressively so, near-term, inflation will be low.
• Spare capacity will persist and act as a downward pressure on inflation until 2021 and even into 2022.

At home, Old Mutual Multi-Managers investment strategist Izak Odendaal is more concerned about deflation taking hold globally than inflation. He says, “Quite simply, the world is experiencing a massive deflationary shock. Demand is depressed relative to supply. Supply is also depressed in many cases, but largely in a way that still keeps prices low. The cost of a haircut hasn’t gone up, even though many (myself included) are desperate for one.”

Those who expect inflation to become more of a problem than deflation argue that the trillions of dollars of monetary stimulus will cause inflation. However, Odendaal notes:

“For this to be inflationary, however, it has to lead to a strong increase in bank lending, which it’s not. Most of the money remains stuck inside the banking system. And even if it ‘leaks’ out, it will just be pouring into a gaping hole left by the disappearance of income for many households and companies, and governments. It can only be inflationary if it exceeds the lost income by some margin.”

Supply-side inflationary pressures, meanwhile, are unlikely to have an immediate impact on prices, he argues, and trends like anti-globalisation need to be set against disinflationary technological improvements.

He adds that the 1970s experience of inflation showed that sustained high inflation needs the following three ingredients: loose monetary policy, high oil prices and an inflexible economy with widespread inflation-indexation of wages.

“Sustained high inflation is like a fire, it needs a spark, an accelerant, and oxygen to keep it going. Only one of those three is not enough.”

Consumer inflation rates in the US and China are low and falling. For instance, the US core inflation rate experienced its sharpest monthly decline in history in April when it fell to 1.4% year on year compared with 2% the previous month. Odendaal points out that declines in core items predictably included airfares (-24% year-on-year), hotels (-16%) and car insurance (-6%).

China’s core consumer inflation rate also declined and its producer inflation rate fell below zero. Says Odendaal: “Bear in mind, China is the world’s largest producer. Those price declines are exported across the globe.”

South African inflation, which is currently close to the middle of the central bank’s target range, is also expected to decline further. In last week’s Monetary Policy Statement, the central bank forecast that inflation will average 3.4% in 2020 and 4.4% in 2021 and 2020.

The bank noted that the overall risks to inflation at this time appear to be to the downside, but less so than in March and April, with electricity and administered prices a concern for the bank. The upside inflation risks are “heightened fiscal risks” and sharp reductions in the supply of goods and services. In the short to medium term, however, market-based expectations for inflation have fallen.

It would be difficult to choose between these two economic evils because both high inflation and deflation would impose significant economic costs that the world can ill-afford right now. However, based on Japan’s two-decade battle against deflation with little success – and with monetary policy coffers everywhere already depleted – authorities will need to do everything they can to nip deflation in the bud before it takes us down an economic path we really don’t want to travel. DM/BM