Will the pandemic result in deflation or inflation?

Inflation plunged last month: the UK consumer prices index (CPI) fell from 1.5% in March to 0.8% in April* indicating that the price of many of the things we buy and consume has almost halved.

With the oil price having slumped and even turned negative at one point, and the global economy having come to a complete standstill due to the pandemic, this is perhaps unsurprising. But the question is, will we see prices fall further in the coming months or will this be a temporary phenomenon?

What is CPI?

Consumer price inflation is the rate at which the prices of goods and services bought by households rise or fall and it is calculated each month using an imaginary – but very large – ‘shopping basket’ containing a mix of goods and services.

What is in the basket changes over time. When it was first introduced more than 70 years ago, the UK still had rationing in the aftermath of World War II – condensed milk was a staple purchase and the cost of a mangle rather than a fridge was included. Today, our basket includes things like ‘free-from’ foods, petrol, computer games, airport parking and gin.

Aren’t falling prices a good thing?

With meals out, package holidays and recreational and cultural services – which are in the basket – all on hold for the foreseeable future, inflation could continue to fall in the short term and even turn negative – or deflationary. This may at first sound like a positive. After all, if your salary is the same, but the things you want to buy become relatively cheaper, you are better off.

The problem is that in this environment you are more incentivised to hold onto your money in savings, rather than spend it. After all, what is the point in buying something today when it could be even cheaper tomorrow? As fewer products are bought, companies’ revenues fall, and this can then lead to higher rates of unemployment and a continued downturn in spending. This is known as a “deflationary spiral” and was the bane of the Japanese economy for almost three decades.

And while petrol prices have plummeted, as most of the population has stayed at home, we’ve not benefited from one of the main causes of the fall in inflation, as we’ve not been filling up our petrol tanks.

Find out more about the different types of inflation

What the fund managers are saying

Dr Niall O’Connor, manager of Brooks Macdonald Defensive Capital says that in the short term, there is likely to be deflationary pressure as demand is so weak. But he also believes supply-side destruction – caused by social-distancing measures – could create pockets of inflation. For example, no middle seats being used in aeroplanes and hairdressers having to have fewer seats in the salon, may well mean prices have to rise considerably to keep these businesses profitable.

“I’m more worried about inflation than I have been in the past,” he said. “Companies have now experienced the dangers of only having one supplier and I think businesses will now turn to multiple sources in their supply chains, which could push up prices in the long-term. Couple this with the colossal wave of money printing by central banks, such as the Bank of England and US Federal Reserve, and the action taken by governments around the world to keep economies going during the pandemic, and the result could be higher inflation. Who is going to pay off the debt? Will we see higher personal taxation and will governments let it ‘inflate away’?

John Bennett, manager of Janus Henderson European Focus, said in his recent podcast that he doesn’t think inflation is a 2020 issue or even a 2021 issue. He thinks this is a deflationary shock that we’re going through.

“The world has been parked in ‘disinflationary beneficiaries’ like bonds and bond-like equities for a long time and has been right to be so,” he said. “The world could change, could turn 180 degrees, and spin on his head, if we got inflation though.”

Listen to the podcast

Stephen Snowden, manager of Artemis Corporate Bond fund, believes the pandemic will prove to be disinflationary in the long run. “Technology is a deflationary force and the pandemic has just accelerated the trend for us to use it more and more in our lives,” he said. “There may be a short-term trend of people buying locally, but I fear that very quickly, human nature will return to buying the cheapest ‘same-quality product’ online – no matter where it is sourced or made.

“Many businesses will only survive what will probably be the worst recession in living history because they are being bailed out. There will still be large scale unemployment though. QE didn’t result in inflation in Japan for three decades. It didn’t result in deflation in the Western world in the ten years after the global financial crisis. I think inflation will be hard to find in the years ahead.”

Whether you are in the deflationary or inflationary camp, Will McIntosh-Whyte, deputy manager of Rathbone Strategic Growth Portfolio says it is worth bearing in mind that inflation is like aging: it shocks you.

“Ageing is not really something you notice on a day-to-day basis,” he said. “You get up every day and the person in the mirror is identical to the one who was looking back at you yesterday. It is only when you step back and take a minute to think about it that you notice getting old.

“In a similar way, I often think investors can too often get caught up in the day-to-day and forget about taking the long view about what they are trying to achieve. If inflation does pick up it will slowly and silently erode cash savings and the real value of your capital. As with ageing, this process is glacial and barely noticeable day-to-day. But, like a terrible photo from your Mum’s album, the consequences may shock you many years hence.”

Read more about how to inflation-proof your portfolio

*Source: Office for National Statistics, April 2020

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