There is now little doubt that central banks have the tools to fight the deflationary spectre, but they also need to prevent prices from running out of control.
UK inflation has just hit a two-year high. Everyone knew it was coming. There is a simple mathematical relationship between the devaluation of sterling and price increases. Before the official figures were announced, Bank of England governor Mark Carney did what modern central bankers do. He used a busy speaking programme to tell the markets what they already knew: that inflation was likely to exceed the bank’s long-term target of 2%.
The BoE’s indifference to its official policy of price targeting was already a matter of historical fact. Carney’s predecessor, Lord Mervyn King, allowed inflation to let rip in the aftermath of the financial crisis, with CPI peaking at a 20-year high in September 2011. Inflation is also rising rapidly in the eurozone and Japan, though from much lower levels.
The picture does not look rosy for those who believe inflation can be boosted and then just as easily controlled
Central bankers are doubtless patting themselves on the back. A debt deflation spiral would have made the financial crisis look like a vicarage tea party in terms of its impact on growth and employment around the world.
With the exception of countries such as Greece and Ireland, the last crisis was a blip when compared with the Great Depression of the 1930s or the Long Depression of the 1870s.
When the history books are written, it may be that the financial crisis we have all obsessed about since 2007 will turn out to have been nothing more than a short chapter in the bigger picture of post-Word War II economic prosperity.
Should investors be so sanguine? The balance sheets of the world’s 10 biggest central banks have ballooned from $6 trillion before the crisis to $21 trillion today. This wave of global liquidity has flooded into asset markets – directly into high-quality bonds via quantitative easing – and indirectly into riskier assets via desperate investors hunting for yield. It is perhaps no surprise that the first signs that unorthodox policy is feeding through to inflation have already led to a sharp rise in yields, especially at the long end of curves.
The long game
So far there is little evidence of contagion across other asset classes. For equities a little inflation may be a good thing, if it helps improve pricing power and boost margins. But too much is likely to lead to higher wages, which will have the opposite effect. The former view is the current perceived wisdom. Capital has kept labour under its thumb since the Margaret Thatcher/Ronald Reagan era.
However, the biggest tailwind for capital was not supply-side economics. It was the fall of the Berlin Wall in 1989 and China’s inclusion in the World Trade Organization 12 years later.
Suddenly, 1.5 billion new workers joined an increasingly globalized workforce. The words ‘offshoring’ and ‘outsourcing’ joined the lexicon. The currently toxic combination of low wage growth and higher levels of unemployment in the west began to take hold. Whether or not one agrees with the vitriolic blustering of the new breed of populist politicians, the cause and effect of these two dynamics that have shaped the global economy since the turn of the century seems fairly plain.
China has enjoyed unparalleled economic growth since and the former members of the Warsaw Pact (with the exception of Russia) have been incorporated into the European Union. But the Chinese workforce is now falling rather than rising as a result of the one-child policy. Russia has had one year of population growth since 1990. Everywhere in the west the population is ageing rapidly. There are fewer workers supporting more retirees.
Some have argued this is deflationary. But that seems counterintuitive. The smaller cohort of workers will be in greater demand and can expect better wages. Recent work by two authors writing under the auspices of the BIS supports the view that a greater number of dependents (young and old) is correlated with higher inflation*.
This is a long-term challenge facing policymakers. A more pressing issue is what to do with all the quantative easing assets sitting on their balance sheets? Unwinding this policy is a far bigger challenge than starting it. Even ignoring the technicalities (which are legion) the market reaction to tighter policy is well known.
The Bank of Japan started QE 15 years ago. Its latest rumoured policy wrinkle smacks of monetization – the government directly buying notes and bills created by its central bank.
The global debt burden will continue to cause policymakers to think long and hard about tightening. Combine this with permanent QE and a change in the demographic landscape and the picture does not look rosy for those who believe inflation can be boosted and then just as easily controlled.
The current upbeat mood of many in the markets seems misplaced.
* BIS Working Papers No 485: Can demographics affect inflation and monetary policy, Mikael Juselius and Elod Takats