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The new inflation

One of the biggest mistakes in formulating strategy is to assume something is going to continue because it has continued for so long. This classic mistake is about to be rolled out in droves by companies over the coming year. The assumption is continued low inflation, because that has been the experience for nearly 30 years following the death of inflation in the early 1990s. However, we now face the best example of "past performance is no guide to the future", in decades. Inflation weakened in the months following lockdown as the economy collapsed, and the sheer scale of economic inactivity opened up a huge output gap i.e. the divide between actual and potential output. This immediate disinflationary effect (slowdown in inflation) could even be followed by deflation (falling not rising prices) in the short-term, although that could be offset to some degree by higher prices as firms seek to re-build revenues post lockdown. However short term disinflation or deflation over the summer in 2020, is no guide to inflation in 2021. A major strategic shift has occurred with regard to inflation. Broad money growth (the growth in the overall amount of money in the economy - notes and coins and bank deposits) has surged in 2020. In the US it has been rising at the fastest rate in peacetime history. In the UK it has attained double digit growth for the first time since before the Great Financial Crisis. In Europe it has accelerated markedly as well.  The surge in broad money supply growth could be offset a little by a fall in the velocity of money (the number of times it changes hands). The amount of money, multiplied by its velocity, equates to nominal GDP. But the scale of monetary growth has been so strong that an acceleration in inflation in the latter part of 2020 and into 2021 now looks almost certain. This will be most apparent in the US, followed by the UK and then the euro-zone. In fact we would have probably seen it already had the surge been immediately channeled into goods and services. In reality the money has poured into equity markets instead. The extent to which that triggers subsequent consumption - through for example wealth effects - will play a big part in deciding the scale of the inflationary fallout next year.  What is clear though is that Covid-19 will mark the end of the 'death of inflation' and its resurrection instead. But if you just look at the latest numbers and view the road ahead as a repeat of that before, you're in for a big surprise.

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