Will the recent worldwide fiscal and monetary moves set the stage for an inflationary future?
The global economy has been brought to its knees by COVID-19, with a collapse in demand unlike anything seen since the Great Depression. Economic shutdowns and social distancing policies have led to mass unemployment and the near-term impairment of entire industries. Authorities have responded with an array of public support policies that have led to trillions in deficit spending and massive monetary easing campaigns. While sweeping policy response is probably better considering the scope of the current crisis, it’s fair to wonder about the longer-term implications of these extreme and unconventional measures.
Preventing a Depression
An enormous output gap—the difference between actual and potential output—has been created by millions of workers sitting idle at home and the economy running well below capacity. Federal Reserve (Fed) Chair Jerome Powell has warned of an “extended period” of weak economic growth saying that “the path ahead is both highly uncertain and subject to significant downside risk.” The International Labor Organisation (ILO) estimates that over 80% of the global workforce lives in countries with mandatory or recommended closures. In the U.S. alone, 36 million Americans are unemployed. Hopefully these shutdowns are short-lived and we can all return to a more “normal” environment sooner rather than later, but significant damage has already been done. Given the nature of the health crisis and the absence of vaccine, it’s entirely possible—if not likely—that the rebound in economic activity will be lackluster. A recent working paper by the National Bureau of Economic Research (NBER) estimates that a devastating 42% of pandemic layoffs could result in permanent job loss.
In response to the uncertainty, consumers have cut spending and increased savings, businesses are slashing prices, and wages are under pressure. Deflationary pressures are all around. The environment today is not entirely dissimilar from the early 1930s, the last time a demand shock of a similar magnitude occurred. Chart 1 shows what happened to the Consumer Price Index (CPI) in the immediate aftermath of the Great Depression (1930-33). The good news is that today, unlike the early 1930s, policymakers seem to understand the gravity of the situation, and are acting to aggressively combat both the fall in real output and intensifying deflationary pressures.
Chart 1: U.S. CPI Inflation, 1927 - 1934
%. As of 3/31/2020
Source: Haver Analytics. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Measuring the Policy Response
By almost all metrics, the global fiscal and monetary response to the current crisis has been incredible, both in magnitude as well as the speed at which the policy support has been deployed. In the U.S., deficit spending this year, as a percentage of GDP, will be close to a 100-year high—eclipsed only by deficits incurred at the height of World War II. If we include the expansion of the Fed’s balance sheet alongside the fiscal response, cumulative monetary and fiscal support in the U.S. is likely to be more than 40% of GDP this year, an astounding figure.
Looking around the world, the policy response has been equally potent. In Europe, Germany, Italy, the U.K., and France have announced even larger fiscal response packages than the U.S. Chart 2 below shows the direct and indirect policy support from around the world. Japan, the world’s most indebted country, announced a $1 trillion stimulus package, roughly 20% of GDP, while the Bank of Japan pledged to buy an unlimited amount of bonds to keep borrowing costs low. These actions go a long way toward preventing economic catastrophe, but they come at a longer-term cost.
Chart 2: The Global Fiscal Response Is Huge When Including All Measures
IMF Estimate of the Q220 Fiscal Response to the COVID-19 Pandemic, % of GDP. As of 4/2020
Source: IMF. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
A Mountain of Debt
Debt, put simply, pulls future consumption forward. If a country borrows to buy something today, that money will have to be paid back over time and will not be available for other expenditures. Debt proceeds can be deployed for productive uses, but too much outstanding debt is not good either. The debt being incurred today to prevent an economic collapse is not productive in the long run. Governments are merely filling the economic hole created by shutdowns and widespread unemployment. The real challenge is that the world entered this crisis with a lot of debt and large unfunded liabilities. At the end of 2019, global debt reached an all-time high, exceeding $255 trillion at over 320% of global GDP. Debt today is almost $90 trillion higher than it was at the onset of the Great Financial Crisis. These figures will grow considerably once we add the bill from the COVID-19 stimulus packages. Therefore, U.S. debt as a percentage of GDP may end 2020 at a century-level high—at least.
Chart 3: U.S. GDP to Debt
% of GDP, SA. As of 5/27/2020
Source: Macrobond Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Over-indebtedness, as a society, has been a structural headwind to growth. There’s a good chance that the debt being incurred today will only serve to weaken future growth in addition to exacerbating the disinflationary trends that the U.S. and other countries are facing. It’s entirely possible that the global economy will emerge from this crisis in an even lower growth environment than the past decade.
Monetary Policy to The Rescue?
As central bankers have become more creative, boundaries continue to be tested. Unconventional monetary policies, such as large-scale quantitative easing (QE) have become commonplace. Even the emerging world has joined the action with at least a dozen central banks s launching QE programs in response to the current crisis. As the lines between fiscal and monetary policy continue to blur, will these actions spark inflationary pressures? In the near term, it’s highly unlikely considering the deflationary malaise that will be with us for some time. Perhaps as the crisis abates, signs of inflation could appear if the money created by central banks makes its way into the real economy. This too, seems unlikely given the longer-term structural headwinds facing the world, including the mountain of debt discussed earlier. The experience from Japan over the past 20 years—and Europe over the past decade—is that bloated central bank balance sheets and unconventional monetary policies alone do not create inflation, nor are they an answer to a low-growth environment.
Perhaps the most concerning by-product of our current situation, and one that would lead to an inflationary outcome, is outright financing of government deficits by central banks—some form of Modern Monetary Theory (MMT). Recently, the Bank of England/ agreed to directly finance the U.K. Treasury for a small amount, over a short period in response to the COVID-19 crisis. While this small action seems harmless, and unlikely to spur inflation, the risk is that once the door is opened, it’s hard to walk back from it. In today’s politically charged environment—and considering how much debt is outstanding—there’s no saying how “creative” politicians might get to finance deficits. What’s easier to sell to constituents: raising taxes and cutting pensions, or having the central bank coordinate policy with the government? Any move to give central banks the power to spend, would be quite negative and inflationary for the country that chooses to walk down this path.
The world is amidst a significant deflationary shock and extreme policy measures are warranted to prevent us from falling into the abyss. But there is no free lunch and these extreme measures will come at a longer-term cost to society, especially when you consider the less than ideal starting point for the current crisis: a massive debt overhang, large unfunded liabilities, and bloated central bank balance sheets. Time will tell how great the cost will be.
Learn more about Brandywine Global’s Macro Solutions:
COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARSCoV-2.
The Great Depression was the worldwide economic downturn that began in 1929 and lasted until about 1939. It was the longest and most severe depression ever experienced by the industrialized Western world, sparking fundamental changes in economic institutions, macroeconomic policy, and economic theory. Although it originated in the United States, the Great Depression caused drastic declines in output, severe unemployment, and acute deflation in almost every country of the world. Its social and cultural effects were no less staggering, especially in the United States, where the Great Depression represented the harshest adversity faced by Americans since the Civil War of the 1860s.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The International Labour Organization (ILO) is a United Nations agency whose mandate is to advance social and economic justice through setting international labour standards.
The National Bureau of Economic Research (NBER) is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.
The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics.
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
World War II, also called Second World War, conflict that involved virtually every part of the world during the years 1939–45. The principal belligerents were the Axis powers—Germany, Italy, and Japan—and the Allies—France, Great Britain, the United States, the Soviet Union, and, to a lesser extent, China. The war was in many respects a continuation, after an uneasy 20-year hiatus, of the disputes left unsettled by World War I. The 40,000,000–50,000,000 deaths incurred in World War II make it the bloodiest conflict, as well as the largest war, in history.
The Bank of Japan (BoJ) is the central bank of Japan and is responsible for the yen currency.
The International Monetary Fund (IMF) is an international organization of various member countries, established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements.
The Great Recession, also known as the financial crisis of 2007–08, the Great Financial Crisis (GFC), global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.
Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.
Modern Monetary Theory (MMT), not widely accepted, has the following basic attributes: A government that prints and borrows in its own currency cannot be forced to default, since it can always create money to pay creditors. New money can also pay for government spending; tax revenues are unnecessary. Governments, furthermore, should use their budgets to manage demand and maintain full employment (tasks now assigned to monetary policy, set by central banks). The main constraint on government spending is not the mood of the bond market, but the availability of underused resources, like jobless workers.
The Bank of England (BOE) is the central bank of the United Kingdom.
Her Majesty's Treasury (HM Treasury, or UK Treasury), sometimes referred to as the Exchequer, or more informally the Treasury, is the department of the Government of the United Kingdom responsible for developing and executing the government's public finance policy and economic policy.
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).
This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.
This material is only for distribution in those countries and to those recipients listed.
All investors and eligible counterparties in EU and EEA countries:
In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office Floor 6, Building Three, Number One, Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4. D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.
In the UK, this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the UK Financial Conduct Authority.
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH.
Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.
All Investors in Hong Kong and Singapore:
This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.
This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.
All Investors in the People’s Republic of China (“PRC”):
This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC. The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission. Investors should read the offering document prior to any subscription. Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only. Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.
This material has not been reviewed by any regulatory authority in the PRC.
Distributors and existing investors in Korea and Distributors in Taiwan:
This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (109) Jin Guan Tou Gu Xin Zi Di 016; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.
This material has not been reviewed by any regulatory authority in Korea or Taiwan.
All Investors in the Americas:
This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.
All Investors in Australia and New Zealand:
This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827). The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.