Inflation rates have fallen in most countries after the Covid-19 shock, but many investors still fear that the crisis will ultimately lead to soaring prices and a regime change away from the "great moderation" that has provided relative stability for decades .
Some point to medieval pandemics and subsequent periods of rising prices and wages due to labor shortages and goods as evidence of looming inflation. Others suggest that the massive monetary and fiscal stimulus introduced in response to the pandemic represent a first step towards a new inflationary regime. And some consider the sharp rise in gold's value to be a harbinger of such a shift.
I doubt any of these signals will give investors a straight answer. It seems more promising to focus on the penultimate factor: a political loss of central bank independence.
While inflation is well below the central bank's targets almost everywhere, its potential resurgence is understandably high on investor worries. Significant changes in this dynamic have a significant impact on investment returns. Past bouts of rising prices have apparently undermined bond yields and at times weighed on stocks.
However, a shift towards significantly higher inflation is at best an end risk, since the risk of so-called fiscal dominance – a prerequisite for such a development – is considerably lower than is often assumed. In the meantime, market signals, macro indicators or standard models of inflation are unreliable or even downright misleading.
A case in point is the recent gold rally. While the precious metal rose sharply in the inflationary 1970s, it rose from 2001 to 2012 during a long period of extremely subdued inflation. And the forecast quality of the market-based inflation expectations is not much better, as they are too strongly influenced by short-term price developments such as oil price movements.
The same is true of monetary aggregates (the monetary base): since the monetary multiplier is very unstable, central bank balance sheet growth is an inadequate predictor of inflation, as Milton Friedman taught us.
Likewise, the relationship between nominal gross domestic product or inflation and the growth of credit aggregates (bank loans) is weak and unstable. The recent rise in this indicator is particularly misleading. The main trigger was the extensive provision of government guarantees for corporate loans. In combination with significantly higher household savings, this led to a massive increase in the monetary aggregates. Neither of these implies that nominal growth in aggregate demand will be sustained higher in the years to come and trigger a sustained rise in inflation.
After all, most investment professionals know that economists' "workhorse" model, the Phillips curve, designed to show the relationship between employment and inflation, has not been a spectacular predictor of inflation in recent years. Financial or business-related approaches therefore don't seem to give a clear answer to our question.
A better approach might be to focus on political economy. Persistently high inflation required complete fiscal dominance over monetary policy, with central banks effectively being forced to fund huge government spending. The crucial question is whether the Covid-19 pandemic will bring us to the brink of such a regime change.
It is premature to draw this conclusion. The financial and monetary authorities enjoy strong political support to shore up the economy and assist those hardest hit by the crisis. However, this should not be interpreted as a consensus in favor of submitting monetary policy to narrow political objectives.
In the euro area, such a regime change is difficult to imagine given the constitution of the European Central Bank and the anti-inflationary stance of the northern states. Some may cite Japan as a prime example of fiscal dominance, but the fiscal and monetary authorities there have worked together to stimulate growth and – so far unsuccessfully – inflation.
A more interesting case is China, where the government has the power to instruct its central bank to provide whatever funds it deems necessary to fund communist party projects. However, China is cautious even amid a severe global recession. It seems that Beijing recognizes the risks that rising inflation could bring, as such cases in the past have proven to be socially and politically destabilizing.
That leaves the USA. Should we expect a shift towards fiscal dominance there? Despite the staggering national deficit and the huge volume of assets the Federal Reserve is buying, it is far too early to judge. Of course, a re-elected Donald Trump could try to undermine the Fed's independence, or a left-wing Congress elected on the Joe Biden basis could pressure the central bank to fund oversized welfare programs.
However, both scenarios would face significant resistance as the political center wants to ensure that the Fed adheres to its low-inflation mandate and remains independent. The consensus may still stem from funding tax programs with tax revenues rather than debt bought by the Fed.
The author is Credit Suisse's global chief investment officer