A deflationary virus
By the end of 2021 (our forecast horizon) GDP levels in both the US and the euro area will be lower than at the end of 2019. In other words, while the extent of the recession – and especially its exact depth in Q2 – is still relatively uncertain, we see a lasting impact on the economy with only a gradual recovery of lost economic activity.
Fiscal measures are cushioning the impact of the virus-containment policies on employment, production capacity and consumer spending, but not entirely offsetting it. The gradual reopening of Western economies will be a gradual process rather than a single event. Restrictions will be very carefully lifted, as will be the rise in demand.
There are fears that the forceful policy response of both governments and central banks combined with supply-side restrictions during the shutdown will lead to higher inflation in Western economies. We believe, rather, that disinflationary forces will prevail when economies reopen. In particular, the sharp negative shock on aggregate demand will dominate the supply disruption impact.
Meanwhile, the collapse in oil prices lately will depress headline inflation figures in the coming months. Our oil scenario remains cautious as we expect the Brent price to fall towards USD 10-20 per barrel in Q2 2020, and then converge to only USD 18 by year-end.
In the US, we expect core (ex-commodities) PCE inflation to average only 1.3% in 2020, and slow further to 1.0% in 2021. The Federal Reserve is therefore unlikely to face a growth vs. inflation dilemma.
In the euro area, we expect headline inflation to fall sharply and turn negative on the back of collapsing oil prices. If oil stays close to current levels, euro-area headline inflation is likely to average -0.1% in 2020 (vs 1.2% in 2019). We estimate that euro-area core inflation will average 0.7% in 2020 (vs 1.0% in 2019) and 0.9% in 2021.
The immediate responses to the Covid-19 pandemic have led to a sharp fall in both demand and supply. The likely damages to the labour market and the fact that recovery will not be a “V”, but rather an “asymmetrical U-shaped” means disinflationary pressures will persist.
Central banks in Europe and in the US should not feel too constrained by a potential inflation dilemma, which at the margin, would incentivise more action rather than less in terms of potential liquidity injections and/or a protracted period of zero (US) and sub-zero (euro area) interest rates.