We think that we can see the shape of the post-pandemic economy emerging. We expect levels of economic activity to be lower than before the pandemic and for rates of activity to be subdued. In the course of the series of lockdowns, the more affluent households have retained a good portion of their cash balances, whilst those businesses that continued to trade profitably have balance sheets swollen with cash. What happens next is likely to be determined by how these economic agents act.
Some households have done very well during the pandemic. If their income has held up - either through continued activity or through governmental support - the imposition of restrictions on many aspects of consumer activity have led to rather large cash balances being accumulated. The closure of non-essential retailers and much of the hospitality sector has ensured that this household disposable income has no natural outlet. How much of that will come back once lockdowns end?
This critical uncertainty gives rise to two schools of thought. In one school of thought, it is held that this money is seen by consumers as spending money. Once they are able to go shopping again, and once consumers feel safe to do so, then there is likely to be a sharp rise in consumption, possibly triggering a bout of mild inflation. The other school of thought has it that households face considerable uncertainty over the future at the moment and that they are increasing their precautionary balances to counter this uncertainty. In this case, a relaxation of lockdowns is not likely to lead to a spending spree. Both arguments have merit. What we are likely to see is a bit of both happening, but we can't be sure of where the balance between the two will lie.
If households have this quandary, what about the corporate sector? Companies face three possibilities over the cash on their balance sheets. The first option would be to return the cash to shareholders, either as dividends or through share buy backs. Many listed companies have reduced their dividends during the pandemic. There is likely to be some shareholder pressure to restore them, particularly if corporate bonuses start to rise again. A second option would be for the companies to invest the cash in future profits. This is only likely to happen if household demand strengthens and if inflation starts to tick upwards. It is the lack of prospective demand that has held back investment for the past decade. Finally, companies can continue to sit on the cash as a policy of 'wait and see'. This has been the predominant policy over the past decade. We are likely to see a combination of each of these possibilities in practice, with, again, the key point being where the balance lies.
At present, the economy is on life support provided by the government. There has been a significant fiscal expansion, financed by the printing of money under QE. Most governments have found the magic money tree and are picking the fruit as it ripens. If households sit on their precautionary balances and if the corporate sector adopts a policy of 'wait and see', then this could be a reasonably stable outcome. The consequence would be low productivity, low growth, relative stagnation, much as we have experienced over the past decade. This is not a recipe for a dynamic economy and the pathway to increased prosperity.
If, on the other hand, the economy experiences something of a bounce back - an even greater government fiscal stimulus, an increase in household consumption, and an increase in corporate investment - then a different result could arise. Stronger demand could suck in imports and weaken the Pound. Both internal and external factors would then lead prices to harden and for inflation to start to tick upwards. At this point, the policy response is critical. If the monetary authorities respond with a monetary tightening, then inflation could abate, pushing the economy back downwards again, much as happened in the Eurozone in 2011, when the ECB tightened far too soon. If the response is not to tighten, then there could be spurt of real economic growth to close the output gap. This could continue for some time if inflation expectations don't rise too fast. The size of the output gap is such that a dramatic increase in the underlying rate of inflation is unlikely for some time to come.
The current inflation expectations are for a rate of about 3% in five years time. That would be within the collar set to the Bank of England, but at the upper end of tolerance. Would the monetary authorities be comfortable with this? Past experience - coming out of the lobal financial crisis - suggests that they would be. A short period of over-shooting the inflation target was accepted as the price for stability in the longer term. There is nothing to suggest otherwise as we emerge from the pandemic.
If all of this is close to correct, then what we can expect to see in the next year or two is an uptick in the headline inflation rate whilst the economy remains overall subdued. This inflation is likely to be temporary in nature owing to technical factors in the calculation of the headline rate. This suggests that a modest inflation may return for a while, but it will be nowhere near as high as the money hawks suggest.
Stephen Aguilar-Millan
© The European Futures Observatory 2021
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