The big macro issue facing us is the question of inflation that results from activity restrictions. I wrote about inflation forecasting earlier, and the key take-away is that CPI prints will depend heavily upon the weight of each component, and the components will be moving in different directions. However, one might want to step up away from CPI forecasting, and ask about the generic supply and demand situation, accepting that the resulting inflation might not be captured by the CPI. My guess is that we will not know for awhile, but I am not exactly holding my breath waiting for inflation.
Uncertainty Fading
The extreme uncertainty that policymakers faced in March is fading. We now have more reliable data on the deadliness of COVID 19.
The main uncertainty revolves around how far and how quickly distancing measures can be relaxed without causing a medical calamity. The biggest challenge is the return to (pre-university) school. Children themselves appear to be less susceptible, but they are certainly a vector for transmitting contagious diseases. Another thing to note is that many people who have the ability to remain in their homes will do so. The implication that there is no policy switch to throw to turn economic activity back on.
Re-Opening Optimism
So long as we view the economy in terms of real activity — and not GDP — I am relatively optimistic about re-opening activity in most developed countries.
I will immediately note that I am assuming that some types of activity are dead and buried until there is a vaccine — international passenger travel, theme parks, bars and dine-in restaurants, live sports events. The other area of concern are high-density cities that rely on public transport. My feeling is that city centres will face a more restrictive regime than the suburbs.
The most important area of disruption revolves around schools and child care. If they are not re-opened, things are extremely difficult for the families involved. However, from a macroeconomic perspective, one may note that student output is not part of GDP.
Once we move beyond businesses that pack their clientele into close quarters (and their support chain), it seems likely that activity can be supported, albeit at a lower level of productivity. Providing safety equipment and spacing workers out should allow for activity with “acceptable” transmission risks.
The real question is testing that theory. We will not find out whether critical production cannot be safely done until persistent shortages appear. Although there are anecdotal reports of highly-centralised industries being crippled by factory outages, many of the apparent problems are the result of the mix of consumption changing, and a lack of supply chains integration. (The most important consumption mix change is the shut-down of restaurant food consumption, while grocery consumption is rising, and the supply chains evolved to be quite distinct. Toilet paper is another example of supply chain splits.)
Why No Worries About Supply and Demand?
The reason why I am not worried about generic supply and demand issues is that my instinct is that most of the activities that cannot be re-opened are largely optional ones, and might be considered luxuries. For example, the inability to eat at restaurants does not preclude being able to buy food at the grocery store, or even prepared meals.
I would divide household expenditures into a few broad categories:
- Necessities that need to be purchased at a high frequency (food, gasoline, utilities).
- Big ticket items that are sort-of necessary (appliances, cars for people who need one to commute).
- Financial obligations (loan and mortgage repayments, rent.)
- Optional purchases (entertainment, choosing to dine out).
High Frequency Necessities For many such necessities like gasoline, there does not seem to be plausible supply chain risks. Even if some particular facility is impaired, there is enough capacity to work around it. Energy is a capital-intensive industry; the days of an army of miners working the coal face is long gone. With the demise of long-distance flights, energy demand has probably fallen more than supply.
The interesting necessity is food. Supply chains are currently snarled, and the production of certain foods is being impaired. However, things like grain production are less affected. Certain foods will spike in price, but others have no reason to rise. Given the ability to substitute foods, household expenditures on foods might not rise by as much as the rise in the CPI.
Big Ticket Items There are some big-ticket products that have complicated supply chains that might be disrupted: cars, appliances. For these items, the purchase timing is often optional. Price hikes would likely cause the deferral of purchases when possible, limiting the scope for sustained inflation.
Roughly speaking, it will be possible to sell forward future production of popular items. People who need the item now will probably be able to buy a less popular item out of inventory. Since people’s desires to go shopping at present appears somewhat low, it should be possible to make immediate sales out of inventory.
Financial Obligations One of the big categories of spending (and CPI) is rent or mortgage spending. Mortgage payments are fixed, and it is extremely hard to see how landlords have pricing power in the current environment. Right now, many are thankful for being paid at all. Although there might be increased desire for a detached house by people being quarantined in an apartment, a major recession is not normally a great environment for bidding up house prices. Outside of home purchases, the notion of supply and demand with respect to this spending category makes little sense.
Optional Purchases. We are then largely left with purchases that are optional. One possibility is dining away from home — which is no longer possible, so the price is moot. The rest of the expenditures are mainly for recreation. In this case. curtailment of supply does not mean that producers have pricing power. In many cases, the ability to buy products in stores may be more impaired than production capacity. Meanwhile, entertainment goods compete against digital products, and the pricing strategy of digital products is to keep prices steady and attempt to win market share. After all, the marginal cost of production of a digital good is negligible (extra server capacity might be needed).
In summary, even if nominal demand is stimulated greater than supply, the immediate necessities required still appear to be supplied adequately. The excess demand would likely translate into delivery delays, or a switch towards digital products.
Wages
The only way to create a sustainable inflation is to cause a steady rise in wages. Given the massive rise in unemployment, I find it hard to be concerned about rising wages.
Various emergency programmes have had the side effect of making it better to remain unemployed than take work. This was somewhat unavoidable, given the difficulty to implement them in a very short period of time, and the objective is to make it easier for firms to re-hire workers. It seems extremely likely that countries will transition to more targeted measures in the coming months, so we can extrapolate these programmes too far into the future.
Concluding Remarks
So long as government support is aimed at income replacement (which is largely the case), the inflationary effect appears to be nearly nil. So long as the food supply chain holds, the existing supply is adequate to meet existing demand for necessities that are purchased at a high frequency.
For non-necessities, the either people can wait for delivery, or the goods and services are often competing against digital products, which have open-ended supply capacity.
Any good inflation story needs a reason for wages to rise, which seems awkward at present.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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