Economy is 'sitting on a time bomb': Deutsche Bank warns of 'devastating' effects of inflation
(Kitco News) The view that inflation is transitory could lead to devastating consequences for the U.S. economy, warned Deutsche Bank in a report.
"The consequence of delay will be greater disruption of economic and financial activity than would be otherwise be the case when the Fed does finally act," Deutsche's chief economist, David Folkerts-Landau, and others wrote. "In turn, this could create a significant recession and set off a chain of financial distress around the world, particularly in emerging markets."
Deutsche Bank disagrees with the Federal Reserve's outlook that the spike in inflation that the U.S. economy will see this year will be temporary and mainly due to base effects.
"We are witnessing the most important shift in global macro policy since the Reagan/Volcker axis 40 years ago. Fiscal injections are now 'off the charts' at the same time as the Fed's modus operandi has shifted to tolerate higher inflation. Never before have we seen such coordinated expansionary fiscal and monetary policy. This will continue as output moves above potential. This is why this time is different for inflation," the report noted. "The effects could be devastating, particularly for the most vulnerable in society."
The world is leaving its previous low inflationary environment. This shift has been accelerated by the massive monetary response to the coronavirus pandemic.
"It may take a year longer until 2023, but inflation will re-emerge. And while it is admirable that this patience is due to the fact that the Fed's priorities are shifting towards social goals, neglecting inflation leaves global economies sitting on a time bomb," Folkerts-Landau said. "Sovereign debt has risen to levels unimaginable a decade ago with large industrial countries exceeding red-line levels of 100% of GDP."
This crisis has been a different beast altogether, primarily because of the amount of stimulus that has been introduced into the economy. Congress has passed more than $5 trillion in pandemic-related stimulus so far. On top of that, the Fed has nearly doubled its balance sheet to almost $8 trillion.
"There is a striking difference between today's response and that of prior financial crashes as today's stimulus dwarfs the response to the crises in 2008 and the 1930s. The current fiscal stimulus is more comparable with that seen around WWII. Then, U.S. deficits remained between 15-30% for four years. While there are many significant differences between the pandemic and WWII we would note that annual inflation was 8.4%, 14.6% and 7.7% in 1946, 1947 and 1948 after the economy normalised and pent-up demand was released," the Deutsche Bank economists stated. "This is why this time is different for inflation."
The Deutsche team pointed out that the type of inflation that is coming could be similar to that of the 1970s — a decade that saw price growth average 7% and even rise to double-digits during certain times.
At the time, then-Fed Chairman Paul Volcker battled high inflation with dramatic interest rate hikes, which led to a recession. And the report warned that this could be what's in store for the U.S. this time around as well.
"Already, many sources of rising prices are filtering through into the U.S. economy. Even if they are transitory on paper, they may feed into expectations just as they did in the 1970s," the report said. "The risk then, is that even if they are only embedded for a few months, they may be difficult to contain, especially with stimulus so high."
In the face of all this, the Fed has promised to keep its monetary policy loose until it reaches its full employment and inflation goals. And while the U.S. central bank remains patient in light of higher inflation, it might miss the opportunity to act in time, the German bank added.
"The consequence of delay will be greater disruption of economic and financial activity than would be otherwise be the case when the Fed does finally act. In turn, this could create a significant recession and set off a chain of financial distress around the world, particularly in emerging markets," the report explained. "Few still remember how our societies and economies were threatened by high inflation 50 years ago. The most basic laws of economics, the ones that have stood the test of time over a millennium, have not been suspended."
In the meantime, U.S. Treasury Secretary Janet Yellen stated that President Joe Biden's $4 trillion spending plan should go ahead even if it sets off higher inflation that could last into next year and leads to higher interest rates.
"If we ended up with a slightly higher interest rate environment, it would actually be a plus for society's point of view and the Fed's point of view," Yellen told Bloomberg on Sunday.