In this Issue:

  • Reflections on Reflation
  • Italy’s Battered Economy
  • Rent Recession

As we discussed in last February’s piece entitled “Inspecting Inflation,” a series of cyclical and secular factors have conspired in recent years to slow increases in the prices of goods and services. No one misses the inflationary spirals of four decades ago, but today’s low inflation has created its own set of problems.

That article was written just before these pages started filling with analysis of the COVID-19 pandemic. The global economy suffered a sudden and severe recession in the second quarter of 2020, as public health restrictions limited commerce. The emergency caused supply disruptions that prompted some prices to jump temporarily. But more lasting damage to aggregate demand eventually caused brief periods of deflation in most major countries last spring.

To address the economic malaise and push inflation towards its targeted levels, central banks around the world pulled out all the stops. Countries that had positive interest rates saw them brought down to just above zero. Unfortunately, interest rates were already relatively low coming into the pandemic, so these steps did not provide sufficient stimulus.

To add impetus, central banks initiated or expanded quantitative easing programs. By purchasing immense volumes of securities, they swelled the sizes of their balance sheets. By the end of 2021, the U.S. Federal Reserve’s balance sheet is expected to approach $9 trillion, more than 40% of U.S. gross domestic product (GDP). For reference, the Fed’s balance sheet totaled around $800 billion prior to the 2008 financial crisis.

Chart 1 Weekly Economic Commentary

When central banks purchase securities, they pay for them by crediting accounts in the financial system. This action creates reserves, which begin circulating throughout the economy. The money supply around the world has consequently surged, unearthing unpleasant memories of the inflation of a generation ago.

The risk of economic overheating has prompted an increase in inflation expectations in many markets, and an associated rise in long-term yields. Market participants blame these developments on a “reflation trade."

“Forecasters have persistently overstated the risk of inflation.”

Today’s inflation fears are also founded on the potential for a surge in activity during the summer months, as advancing immunity to COVID-19 allows durable economic reopening. There is undoubtedly pent-up demand for experiences that have been risky during the pandemic, such as travel and restaurant meals. The means to sate that demand can be found in the form of excess saving and lots of extra credit in banking systems around the world.

Chart 2 Weekly Economic Commentary