What Natural Disasters Can Tell Us About The Impact Of COVID On Inflation

There’s been a number of recent papers on the impact of pandemics on economies. A Fed paper looks directly at pandemics going back to the 14^th century and finds that they cause real interest rates to fall and wages to go up as a large portion of the labour force dies. A BIS paper models the likely impact of COVID on growth in coming quarters based on assumptions around which parts of the economy will shut down. However, there isn’t much work on the impact on inflation. We therefore delved into the academic literature and found a potentially relevant paper by the ECB on the impact of disasters on inflation.

Main Result

The punchline of the paper was that disasters have a muted impact on inflation. Headline inflation tends to go up by between 0.1% and 0.3% in the first few quarters around the disaster (Chart 1). Much of that is led by a spike in food prices, which offsets falls in energy prices. Housing costs tend to fall, so the impact on core inflation tends to be negative. Because of the greater weighting towards housing in advanced economies, this leads to differing paths in advanced and emerging market inflation rates. Advanced economies tend to see a drop even in headline inflation around disasters, while EM countries tend to see rises (Chart 2).

Types Of Disasters And COVID

The effects they do have frequently depend on the specific circumstances of the disaster and the product in question. For example, a drought that decreases the supply of animal feed and increases prices for farmers could result in increased culling of herds. And that would mean lower near-term but higher medium-term meat prices. Meanwhile, modest flooding generally lowers food price inflation for a couple of years as the benefits outweigh the costs, although severe flooding can destroy housing stock and increase house prices and rent. The specific circumstances of COVID-19 will dictate the outcomes, and this is no ordinary disaster.

Food Prices And The Economy

Even outside of disasters, food prices tend to be one of the more volatile, but less persistent, components of headline inflation. During disasters are no different, and while there is frequently a positive effect on food prices, the effects are short-lived. Because of the lack of persistence, predictable changes in food price inflation typically lie beyond the policy horizon for central banks, and so they typically won’t react. Although higher inflation lowers the real interest rate and might be considered stimulatory in some ways, higher food prices can also be a drag on growth in developing countries where it is a substantial component of the consumption basket.

The COVID Circumstance

The increase in food prices of most disasters results from disruptions to supply or infrastructure, and neither apply to the present situation. For the case of coronavirus, we might see food price inflation for a different reason, as consumers shift from eating out regularly to exclusively cooking at home, and this puts strain on conventional supply lines.

While conventional disasters like drought and earthquakes have primarily supply-side effects, COVID-19 has pronounced demand-side effects as well. Coronavirus has created a surge in demand for sanitation and sterilization products, and a variety of semi-durable products.

The Importance of Housing

The largest impact of disasters on inflation, however, is to lower rent and housing prices, although exceptions include cases in which the disaster itself results in the destruction of a substantial amount of the housing stock (for example, the Canterbury earthquakes in New Zealand, or Hurricane Katrina in New Orleans). Since the coronavirus has no impact on the supply of housing, the impact on housing costs will be negative. The quantitative impact is an open question, however. It depends both on the extent and nature of fiscal stimulus in various countries, and on social capital and the willingness of landlords to accommodate their tenants under these exceptional circumstances.

Impact of government intervention

The paper finds that governments may create demand surges in their attempts to build up the capital stock following a disaster. While nothing has been destroyed in today’s COVID case, we could see a demand surge based on how countries invest in their health systems or large infrastructure projects (that now becomes more politically palatable).

There could also be potential important migration shifts. After disasters, migration rates surge to unaffected regions. We could see people today move to regions with better health systems. These demand surges could increase medium term inflation.

Bottom Line For Today’s Disaster: COVID

The ECB paper provides a reference point for today’s COVID shock. The examples of past natural disasters suggest that there will be divergent inflation trends in advanced economies and emerging markets which hinge on weightings towards housing and food. Housing costs tend to fall, while food costs rise. However, there are important differences to COVID today – notably there is no destruction of physical capital unlike natural disasters. Plus, we have unprecedented levels of policy intervention which could impact inflation expectations, which in turn could be the bigger driver of inflation rates. The next few CPI prints will provide useful markers on how different COVID is compared to natural disasters.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.