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Inflation and COVID-19 Supply Disruptions in Relation to Sovereign Debt

This commentary takes a view on the impact of higher price inflation on sovereign debt and associated risks. Coronavirus Disease (COVID-19)-related lockdown dislocations combined with massive fiscal support to disposable income are fueling price inflation as economies make their recoveries. Energy, transport, raw material and other input shortages and bottlenecks are the main contributing factors. While shortages and bottlenecks mostly are likely to be transitory and commodity price inflation should ease due to base effects, upward price expectations could lead to second round pressure on wages in coming quarters. At the same time, strong demand for labour, along with still low labour participation, could increase wage pressures. Low labour participation is especially notable in North America. Less accommodative monetary policies have commenced in the US, Canada and Australia, while policies are unchanged in most of Europe, where price inflation drivers appear less strong so far.

Key Highlights:

1. Sharp price inflation mostly transitory, but core inflation could stay higher for longer.
2. Employment/selling price expectations increasing, indicating higher prices/ wages ahead.
3. Some increased inflation could be positive for sovereign debt sustainability, provided this is not followed by a period of higher real interest rates. The potential adverse effects are mitigated by declining financing needs and favourable debt profiles.

“Some inflation is positive as it lowers real interest rates and generates higher fiscal revenues,” comments Thomas Torgerson, Co-Head of Sovereign Ratings at DBRS Morningstar. “However, should these trends continue, central banks may find themselves shifting from less policy accommodation to monetary tightening needing to increase policy rates and/or reduce asset purchases more aggressively to avoid severe de-anchoring of inflation expectations,” comments Nichola James, Co-Head of Sovereign Ratings at DBRS Morningstar. “A more rapid monetary policy tightening than expected is manageable provided it is timely and credible.”