While the coronavirus crisis will have both upward and downward effects on prices, we expect the net impact to be significantly disinflationary, for the advanced economies at least, over the next year or so.
- We have condensed this edition of the Inflation Watch to focus only on timely data and coronavirus effects.
- While the coronavirus crisis will have both upward and downward effects on prices, we expect the net impact to be significantly disinflationary, for the advanced economies at least, over the next year or so.
- As with any economic shock, the virus could be either inflationary or disinflationary depending on whether the resulting fall in activity reflects constrained supply (which would push prices up) or weak demand (which would weigh them down). The reality is likely to be a mixture of the two.
- In the near term, price effects will be difficult to discern given that a host of economic activities have stopped altogether and related prices are being measured incorrectly or even not at all. But we have already seen some evidence that limits to the supply of key goods have caused price pressures to increase. In China, for instance, food inflation rose further in February (see Chart 1), despite the fact that the previous intense inflation effects of African Swine Fever are easing. We have little data to go on for advanced economies, but the surge in supermarket sales ahead of lockdown measures seems likely to have prompted similar increases. Prices of some manufacturing components in short supply may rise too.
- But at the same time commodities prices, most notably oil, have fallen sharply. The collapse of the oil price to $23pb at the time of writing is set to knock around 1.5%pts off the average headline inflation rate for OECD countries. (See Chart 2.) Given that inflation averaged 2.3% in February, the fall in the oil price alone will cause the average headline rate to drop below 1%, albeit temporarily.
- And while swings in commodities prices and the effects of supply disruption are likely to be relatively short-lived, weakness of demand will be longer-lasting. The disinflationary effects of depressed demand already seem to be dominating. In China, February’s rise in food inflation was more than offset by a drop in core inflation to a nine-year low. Meanwhile, PMI output price indices for the advanced economies dropped beneath the “no-change” level of 50 in March. (See Chart 3.) The manufacturing index will have been heavily influenced by lower oil prices, but there was an even sharper fall in the index for the services sector.
- The recent surge in initial jobless claims in the US and Universal Credit applicants in the UK suggest that unemployment is set to soar, which will reduce aggregate incomes. (See Chart 4.) For those still in work, a looser labour market may well dampen wage growth. And even in countries where governments are introducing income subsidies for those in affected businesses, like in the UK, pay is set to fall sharply.
- Based on conventional measures of trend growth and the output gap, our forecast for GDP in DMs to contract by around 5.5% this year appears consistent with core inflation plunging to minus 1%. (See Chart 5.) But such estimates are meaningless at a time when the extent of damage to the economy’s supply capacity is unknown. And the flatness of the Phillips curve suggests that increases in unemployment are unlikely to cause wages to fall. (See Chart 6.) So, the impact on core inflation will be more muted.
- On balance, we suspect that the crisis will reduce inflation in the advanced economies by around 1%pt this year and core inflation by perhaps half that amount. We assume that headline inflation will return to roughly its pre-crisis pace in 2021 as energy inflation rises again. A partial recovery in demand should boost the core rate somewhat, but it is likely to remain below its pre-virus rate next year.
- The crisis may have inflationary implications in the long term given the huge fiscal and monetary stimulus that is being provided and the risk that governments will later try to inflate away their debt. But Japan’s experience suggests that they might not achieve this even if they try. And the fall in long-run measures of market inflation expectations suggests that there are risks to the downside too. (See Chart 7.)
- In the emerging world, inflation in China should fall sharply over the coming months as the drop in the oil price feeds through and demand remains subdued. But in many other countries, the disinflationary effects of weak demand and lower oil prices will be offset by the inflationary impact of currency weakness. There will be regional differences, but on aggregate we suspect that EM inflation will be less affected than that in advanced economies over the next two years. (See Chart 8.)
Chart 1: China Consumer Price Index (% y/y)
Chart 2: Oil Price & Energy Contrib. to OECD Inflation
Chart 3: Output Price Component of DM Manufacturing & Services PMI
Chart 4: US Initial Jobless Claims & UK Universal Credit Applications (000s)
Chart 5: Output Gap & Core Inflation in Advanced Economies
Chart 6: G7 Phillips Curves
Chart 7: 5-year/5-year Inflation Swaps (%)
Chart 8: Inflation Forecasts (% y/y)
Sources: OECD, Refinitiv, IHS Markit, Capital Economics