The Scylla and Charybdis of anchoring inflation expectations
I came across some good commentary at PIMCO on inflation expectations I wanted to share with you. I think this is an important discussion in terms of possible economic and bond and equity market paths going forward. In recent posts, I have talked a decent amount about inflation expectations, which I first brought up in May of last year when talking about "market discipline for fiscal imprudence and the term structure of interest rates."
As I said then:
[L]ong-term interest rates are really a series of short-term rates smashed together. The real reason that the Federal Reserve would lose control over short-term interest rates is because the economy was operating at full capacity and creating inflation which provoked an increase in rates.
My point is, unless the U.S. economy starts operating at full capacity, consumer price inflation isn’t going to create interest rate pressure for the Fed. A central bank issuing debt in its own currency controls short-term rates. So, absent inflationary pressure when there isn’t significant slack in the economy, rates remain low.
I think this is significant when thinking about bond market vigilantes and the like. But the key takeaway from the Japanese experience is the one I just outlined: sovereign central banks control short-term rates in the currency they issue and through the term structure, they also have some control over longer-term rates. When there is slack in the economy, there is only so far the bond market vigilantes can go. I’m not saying rates can’t rise. I’m saying that that rise is capped if an economy is in a balance sheet recession.
What I think this means is that unless inflation expectations become unanchored and feed through into wage gains, demand destruction, recession and debt deflation will take over. That’s what I meant when I was talking about this technical recovery being an interregnum between recessions in a broader depressionary phase. I reiterated this when I made a few brief comments on America’s fiscal choices earlier in the week. So I want to concentrate on bullets 4-8 in the framework I have been using since October 2009.
- Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
- Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
- As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
- Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
- From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.
This sequence depends on a number of political and economic factors. Let me outline my updated thinking on the likeliest path.
First and foremost, it depends on U.S. policy makers turning toward a policy of ‘expansionary fiscal contraction‘ as a response to large deficits. This policy will reduce aggregate demand by reducing the government’s spending.
The question is what happens in the private sector. The financial sector balances sum to zero. Let’s assume we don’t see a huge fall in the dollar’s value that boosts exports more than the dollar value of imports. Then the adjustment falls to the private sector to make up for the reduction in the government sector’s deficit. A reduction in government spending could be met by a reduction in the private sector’s net surplus that fills the demand gap via business capital spending, consumer releveraging, etc. Or the private sector surplus remains about the same and the economy contracts. Remember, households have bloated balance sheets. If we assume that people are trying to draw down on their debt and increase their savings, it is reasonable to believe that the government’s reduction in spending will be met by a reduction in private sector spending.
That’s a lot of assuming I am doing there but I hope it makes sense. What I am saying in brief is that a loss of government spending will translate into a loss of consumer income and thus into less consumer spending as well. That means the potential for recession is high. That is certainly the experience in Ireland, the UK, Latvia, Estonia and other countries that have attempted to undergo austerity, what I am henceforth calling ‘expansionary fiscal contraction’.
Meanwhile, as we have seen, the monetary authorities will be adding a lot of liquidity to counteract the impotence of the fiscal agents. In an environment of low to negative real yields, this translates into a speculative risk-on market environment. That has been short- to medium-term bullish for stocks and other risk assets. The liquidity has also created some currency revulsion as medium-term inflation expectations have increased. That’s bullish for precious metals and commodities.
The commodities price inflation will create a problem for policy makers. No one wants to see inflation, especially the sort of regressive tax that commodities price inflation represents. This is the sort of thing that creates geopolitical tension and political instability as we have seen in the Middle East in particular. Developed economy monetary authorities have been loath to cut their policy accommodation short because they fear deflation more than inflation at this point. In Emerging Markets too, monetary policy has been slow to react to the inflation because of a fear of hot money flows or currency pressure. The ECB was the first major CB to react. The Fed will continue to be behind the curve. But, if commodity price inflation feeds through into consumer prices, their hand will be forced. My sense is that eventually all CBs will be forced to move if commodity price inflationary pressures build too much, irrespective of core inflation.
The key part of my analysis here is that the inflation or the rate hikes will create demand destruction before inflation becomes embedded and that means recession or a cyclical slowdown. This will be negative for profit margins, negative for stocks, negative for risk assets and positive for bonds. Countries that issue in their own currency like the UK, the US, Switzerland or Canada could see yields fall as investors flee risk assets. The timeframe here depends on when the commodity price inflation starts to bite or when it starts to become embedded.
That brings me to Pimco’s piece on anchoring inflation expectations. Richard Clarida summarises his piece with these three bullet points:
We really don’t know if longer-term inflation expectations are well anchored. We just know they tend to adjust slowly to actual inflation.
The substantial economic costs of bringing down high inflation are largely due to the need to bring down inflation expectations.
Most central banks that recently enacted unconventional monetary policies are seeking to exit from them.
I think this is the important passages to take away:
But just as there is a large economic cost involved when implementing disinflationary policies in response to surging inflation expectations, there is also a potentially large cost involved in allowing deflation to persist (or worsen) when inflation expectations collapse: Witness the experience in Japan since the 1990s. Deflating economies rarely prosper – there is a reason the phrase “the Go Go 1930s” never did enter the lexicon – and deflating financial systems often founder as nominal financial obligations incurred earlier (the Go Go 1920s?) when inflation was positive are much more difficult to service when prices, wages, revenues and profits are stagnant.
In addition, deflation itself can complicate policymakers’ efforts to engineer the reflation that can pull the economy out of its deflationary trap, a trap in which expectations of future deflation beget ongoing deflation. Central banks are limited by the zero lower bound on the short-term policy interest rate that in normal times they adjust to keep inflation close to target and output close to potential. At the zero bound, which many major central banks bumped against in darkest days of the financial crisis, the remaining monetary policy options available are all “unconventional”: quantitative and credit easing, unsterilized foreign exchange intervention, or providing banks unlimited liquidity against a wide range of unorthodox collateral.
Unconventional measures helped stabilize the global economy after its collapse in the winter of 2008–2009 and, since then, have continued to support an ongoing if uneven recovery in global economic activity. However, these policies were not implemented without concerns about their actual or potential collateral costs. Most, if not all, central banks that recently enacted unconventional monetary policies are seeking to exit from them at the earliest appropriate time – and immediately communicate to the markets their strategy for doing so.
Clarida is making the argument I made above about CBs fearing deflation more than inflation and their policies having unintended negative consequences in commodity asset markets and in terms of malinvestment. Sure these policies have prevented a Great Depression so far but now the unwind is at hand.
The problem is inflation expectations.
[A]ccording to the pessimistic view, inflation expectations appear to have a significant inertial component (sources: Jeffrey Fuhrer and Gerald Moore, “Inflation Persistence” (1995), and N. Gregory Mankiw and Ricardo Reis, “Sticky Information Versus Sticky Prices” (2002)). Thus, the modest adjustments in longer-dated expected inflation may not be the result of Fed credibility to generate and moderate inflation in the future, but instead may only be the result of the Fed delivering 2% inflation in the past. Under this view, if inflation were to rise and stay well above current levels for some time, as it has in the U.K., expectations of rising inflation could become entrenched in longer-dated expectations. That is, we could see a return to the pattern observed during the great disinflation, with long-term inflation expectations converging to short-term expectations. And we perhaps already see some evidence of this over the past few months (see Chart 1).
The truth is we really don’t know if longer-term inflation expectations are well anchored. We just know they tend to adjust slowly to actual inflation. That’s the good news. The bad news is once expectations have adjusted upward, it is hard to believe it will be easy to bring them down again. Unless, of course, you are an optimist.
I would argue that inflation expectations are rising as we speak. They are still anchored but they will not be if they continue to rise any more. And if inflation expectations become unanchored, it will mean that policy tightening will have to be much more aggressive – and that leads us back to debt deflation in a hurry –exactly the problem CBs wish to avoid. If CBs are prudent, they will not only be aware of this Scylla – Charybdis conundrum, but act in order to keep the global economy away from either outcome.