Though they might not admit it now, a number of commentators argued in the immediate post-crisis years that quantitative easing (QE) would cause inflation to rise to worrying levels in countries such as the US and UK.
At the time, I argued this view was likely to be wrong because there remained significant spare capacity in the global economy and concerns voiced over the impact of inflationary consequences of QE reflected a fundamental misunderstanding of the monetary transmission mechanism.
This erroneous interpretation of monetarist economics mistakenly focussed on the monetary base rather than broad money supply in the real (non-financial) economy.
Contracting bank balance sheets and wider deleveraging was at the same time constraining money creation more broadly, even as various central banks created trillions of additional reserves in the banking system. Financial deleveraging was an even greater headwind in the UK and euro area.
Central Bank purchases of bonds from financial organisations in return for new bank reserves does not directly increase money held by households or businesses. It should be obvious that this process has no implications for inflation, beyond the indirect effects via asset prices and confidence.
Instead, I suggested three things to observe before we even start worrying about a rise in consumer price inflation:
(i) the economy operating at full employment;
(ii) high asset prices; and
(iii) much easier credit conditions (than prevailed at the time).
Without a tight labour market putting upward pressure on wages, it was hard to imagine much inflation. Higher asset prices were a prerequisite as the mechanism by which low interest rates and QE would have an effect. A healthier banking system was necessary to supply credit to those who wanted it and end the drag on the broader money supply.
If we look at these criteria in the context of the US economy, they have been met. The unemployment rate is close to most estimates of full employment (including the Fed’s) and wage growth has been accelerating (albeit moderately) for two years.
The other conditions have also been fulfilled. The net household wealth to income ratio has hit all-time highs. Lending and broad money have been growing at healthy rates for some time.
Will the economy run hot?
We are sceptical of paying too much attention to forecasts of these cyclical dynamics in the conventional sense, because the world is highly uncertain and therefore frequently surprising. Any forecast is necessarily probabilistic.
However, if one believes inflationary trends have a cyclical component then it would seem reasonable, on the face of this evidence, to think the odds of US inflation running at or above the Fed’s target for a while are the highest they have been for a decade. This applies if one thinks about inflation in terms of conventional output gap relationships or, indeed, a monetarist framework. And it would be welcomed by the Fed if they truly want to let the economy ‘run hot’.
Structural determinants of inflation
The caveat to the above analysis is that it is entirely cyclical. It ignores some long-run structural developments which we have long believed to be extraordinarily powerful disinflationary forces.
As Eric recently argued, the pro-market, pro-capital and pro-globalisation political consensus that emerged out of the late 1970s (reinforced after the collapse of communism) played a profound role in defeating inflation in developed economies.
Heightened competition globally, along with rapid technological change, provided strongly disinflationary dynamics. In more recent years, ageing demographics and higher debt levels have most probably also exerted a downward force. Central bank policy undoubtedly contributed to the decline in inflation through the 1980s, but has probably played a smaller role once inflation expectations stabilised at low levels.
Is there any reason to suggest the prevailing regime has changed?
From the technological, demographic and debt angles it would seem unlikely. It is conceivable that stronger demand growth might even spur greater investment in productivity-enhancing technologies.
It is the policy regime which now appears much more uncertain, however, and this is where the shock may come. A generalised retreat from globalisation or abandonment of existing monetary/fiscal policy convention seem much more plausible today given rising populist tendencies.
Making these structural observations before they were fully acknowledged by the market would have been extremely profitable for investors. As we have discussed, the structural inflation picture explains why both bonds and equities have delivered strong returns over recent decades, and why they have done so with negative correlations over shorter time horizons, allowing for lower volatility in multi asset portfolios.
However, prevailing yields on developed market government bonds suggests that the scope to generate further returns from this observation is limited at best. The chart below shows the yield on a basket of G7 government bonds. Even with the recent sell-off, they remain below the G7 inflation rate.
Disentangling current cyclical dynamics in inflation, including the central impact of oil price (as we discussed early in 2016), from longer term structural forces is complicated. The challenge to the policy making consensus, the rise of populism, and Donald Trump’s actions in America could represent a fundamental change in the inflation regime. But even if the regime does not change, prevailing G7 government bond yields are offering negative real returns at a time when cyclical inflation risks might be pointing upwards.