Inflation: lower for longer is not forever

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No pandemic lasts forever: However, the COVID-19 shock will leave a significant surge in debt in its wake. This could spell serious trouble for weaker companies and governments once nominal and real interest rates rise again. The outlook for inflation and thus for monetary policy will be a key factor for economic performance and financial markets in coming years.

A turning point for inflation: In this report, we look at the key issues that will shape the post-COVID-19 inflation outlook in the advanced world. We conclude that the 40-year trend of declining inflation has likely run its course. We expect underlying inflation to rise gradually on trend over the course of this decade after a final dip over the next six to 12 months.

Down first: Near term, elevated unemployment and restrained consumer spending will weigh on underlying inflation in the advanced world. The ongoing monetary and fiscal stimuli will take time before they offset the disinflationary pressures stemming from the COVID-19 downturn.

The return of inflation: Once economies and labour markets have recovered the COVID-19 losses, the outlook for inflation and thus for economic policy as well as for markets will change. Some de-globalisation of trade in goods, increased fiscal activism, a stronger role for the state in many sectors of the economy and a more strategic (and hence less efficiency-oriented) industrial policy suggest that underlying inflation will be somewhat higher eventually than it was before the pandemic. The ageing of societies (Chart 1) and the structural shift to labour-intensive services in health care, nursing care and entertainment will add to that.

Better times ahead can mean more inflation: While average productivity growth among advanced economies may rise on trend, aided by the faster dispersion of technological innovations in the wake of the pandemic, history shows that faster productivity gains can go along with more inflation if wage and spending increases exceed the rise in productivity.

Trouble ahead for weaker debtors - but not yet: Even if the upturn in inflation turns out to be gradual and modest, as we expect, governments and companies will have to grapple with less expansionary monetary policies and less favourable financing costs. For most of those who had entered the pandemic with a healthy starting position, this should not be a serious problem. The rise in revenues resulting from the recovery in economic activity should allow them to bear the burden and reduce their debt ratios over time. But countries and companies that i) looked shaky even before the pandemic; ii) suffered very badly during the downturn; and/or iii) are hit by the lasting structural shifts caused or accentuated by COVID-19, will eventually face serious problems from rising financing costs. This may well include Italy and, possibly, even the US.

Holger Schmieding

Chief Economist

+44 7771 920 377

holger.schmieding@berenberg.com

Kallum Pickering

Senior Economist

+44 20 3465 2672

kallum.pickering@berenberg.com

Disclosures

This material is intended as commentary on political, economic or market conditions for institutional investors or market professionals only and does not constitute a financial analysis or a research report as defined by applicable regulation. See the "Disclaimers" section of this report.

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