COVID Stimuli: The Looming Threat of Inflationary Pressures

In late February, Michael J. Burry — the notorious Wall Street investor at the center of the movie “The Big Short”— sent a chill down thousands of spines. “People say I didn’t warn last time,” Burry published on Twitter in reference to the 2007 subprime mortgage crisis. “I did, but no one listened. So I warn this time. And still, no one listens. But I will have proof I warned.” In a series of now-deleted tweets, the Scion Asset Management chief broke down elements of the ongoing economic situation in US markets, pointing to what he claims are Modern Monetary Theory (MMT) policies enacted by the American government aimed at expanding the economy’s money supply. While rampant inflation resulting from the increased availability of liquidity is currently unlikely in Canada, this concern should be addressed due to its potentially dreadful consequences for any economy facing similar conditions.

In a context of high individual and business indebtedness, the tool that central banks typically leverage — interest rate hikes — could result in widespread bankruptcies caused by rising interest payments and bank rates. In Canada, where household debt reached 171% of disposable income in December of 2020, a spike in rates while the capacity for consumers to absorb hikes is low could be ruinous for millions. This situation begs the question, what exactly was Burry referring to, and how likely are his predictions?

The high-profile investor targeted three problematic factors within the American economy in times of COVID: the brisk debt-to-GDP ratio, the sharp increase in the M2 money supply while sales and the PMI index face a V-shaped recovery, and the stimulus packages combined with the gradual reopening of the economy while labor and supply-chain costs skyrocket. However, the unprecedented size of COVID stimulus packages on its own is not enough to bring about uncontrolled inflation. Several factors call for consideration; for instance, the self-fulfilling prophecy where consumer expectations would bring about inflation whether rationally expected or not, as well as the time-lapse over which the stimuli come into effect.

Dr. Ling Ling Zhang, professor of Economics at McGill University, highlights that variations in the rate of inflation during times of crisis are normal. With the pandemic acting as both a supply and demand shock, there are opposing forces — inflationary tendencies on supply and deflationary ones on demand — causing both phenomena to occur side by side. She also noted several other factors, particularly consumer expectations, that could feed into inflationary tendencies.

What about the themes pointed out by Michael J. Burry — how probable is the scenario put forward, and which of the three issues raised in his series of tweets should we be most alarmed by? While these points are relevant in today’s climate, the exponential growth of debt in Canada and abroad should raise a red flag. Several economists, including Dr. Zhang, agree that the expanding debt burden constitutes an issue. The World Economic Forum reported that global debt had reached $277 trillion by the end of 2020, or 365% of world GDP — in large part due to costly COVID stimuli. Last year, Canada saw the world’s highest year-over-year increase in its debt-to-GDP ratio, currently estimated at 80%. Not only would a debt crisis be enough to devastate our economy, but it may heavily contribute to inflationary pressures. As firms face increased costs for their debt obligations, the most likely scenario is a series of hikes in their goods and services offered — thus increasing the likelihood of inflation.

To that end, Dr. Zhang also prudently discussed the issue of expansionary fiscal policies. She believes institutions should consider the length of the lapses over which the stimulus packages will take effect. In the ongoing recession, these stimuli are meant to spur growth in the abnormally low level of aggregate demand; accordingly, expansionary fiscal and monetary policies should not bring about inflation. However, because some of the stimuli's effects may take up to several quarters to spread throughout the economy, a major caveat remains. If consumption and production return to normal levels by the time those impacts kick in, there would likely be upward pressure on inflation, not on national GDP as intended. This potential delayed effect is hard to predict and may only manifest itself once inflation starts to rise.

Finally, considering the Bank of Canada’s (BOC)  inflation target of 2% — or within the 1 to 3% range — what is the most likely scenario for the coming years? “There are tons of economists working on the prediction of inflation, and that’s their job,” Dr. Zhang asserted. “[the BOC’s] main goal is to keep inflation between 1 and 3%. As soon as they observe something, they will have to apply monetary policies to push down inflation: The Bank of Canada can do the job.” The BOC has all the necessary monetary tools to curtail unbridled inflation in the Canadian economy. As one of the world’s most influential central banks, Canadians should feel confident in its capacity to meet its mandate.

While rampant inflation beyond the central banks’ targets remains unlikely, the risks posed by the government’s approach to analyzing fluctuations in the rate of inflation should remain top of mind. Potential discrepancies between the data being considered by policymakers and the reality faced by markets is an issue that has only recently been brought to light. In July 2020, Harvard University professor Alberto Cavallo published in the National Bureau of Economic Research a new measure of inflation based on credit and debit card purchasing data, arguing that the currently used inflation index lacked precision. With the “Covid Consumption Baskets,” professor Cavallo indicated that the Consumer Price Index (CPI) — the official measure of inflation — underestimated inflation in Canada by approximately 0.2%. In the United States, official measures were similarly off by 0.5%. If this is the case, central banks have the responsibility to adjust their estimates accordingly, as the accuracy of their monetary policies depends on it.

To ensure that Burry’s predictions do not come to pass, elected officials’ fiscal policies must remain aligned with the central banks’ decisions, guided by accurate measures of consumer inflation. Furthermore, as economic and financial programs may take several quarters to fully take effect, it would be wise to synchronize the end of stimulus packages with the predicted time of economic recovery. Ultimately, a combined outlook going beyond the spectrum of the ephemeral COVID recession, which eventually ought to end as vaccines allow our economies to reopen, will be critical in preventing a worsening of the ongoing economic turmoil.