The great inflation comeback

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After years of low inflation, a forecast of 5-10% seems incredible – but not if there’s a huge shift in the way the global economy functions.

Central banks are consistently failing to meet inflation targets and the prevailing wisdom is that the current low inflation, low-interest rate scenario is here to stay. Bankers have long since given up hoping that wider net interest margins will assist them in their struggle for returns. Yet, according to two economists at least, the global economy is on the verge of a tectonic shift that will send inflation rates in advanced countries up to between 5% and 10% annually.

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Former member of the Bank of England’s monetary policy Charles Goodhart and former Morgan Stanley managing director Manoj Pradhan have written a book called The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival.

Their argument is that the key factors that ushered in the present low-inflation era – the growth in the global labour market through the rise of China, loss of the power of trade unions to push up wages, increased globalisation and competition that reduced prices – are coming to an end and even going into reverse.

Over the next 20 to 30 years, China and the west will both face an ageing crisis with large rises in dependency ratios – the number of elderly retired that each member of the working population has to support. In the west especially, there have already been huge challenges as to how to pay for the additional medical, care and pension costs of an ageing society even before the Covid-19 pandemic.

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The upshot of the pandemic and the ageing crisis together will be an unsustainable public debt burden. On top of this globalisation is going into reverse as companies respond to the supply chain problems of the pandemic and repatriate production. Fewer workers to do more jobs including those of caring for the elderly and working in the repatriated manufacturing sector will push up wages, reduce inequality and cause inflation.

THE UPSHOT OF THE PANDEMIC AND THE AGEING CRISIS TOGETHER WILL BE AN UNSUSTAINABLE PUBLIC DEBT BURDEN.

All things being equal central banks would respond to the resulting inflation by raising interest rates. But under pressure from governments and companies staggering under high debt burdens, this will prove politically impossible, argue the authors. Instead, the economic escape valve will be inflation rates of 5% to 10% beginning a year or so after the post-Covid recovery.

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How would banks fare in such a scenario? That will depend upon their ability to increase net interest margins at a time of continuing low-interest rates and the extent to which corporate bankruptcies proliferate when rates eventually do rise. Under moderate inflation, they would probably perform better than now but the danger with inflation is that it runs out of control and ends up causing huge economic damage.

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The wildcard in the Goodhart/Pradhan thesis is technology. Does the growth in artificial intelligence and robotics cause sufficient job losses to counter the increased bargaining power of labour and does the productivity growth it enables to provide the new wealth that solves the public debt crisis?

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These are huge questions, critical to the business, and on which economists are unlikely to reach a consensus. A fascinating online discussion organised by the Centre for the Study of Financial Innovation explores these issues with the authors of the book

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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