Will the real elephant please stand up
Will the real elephant please stand up
Perhaps the most often, and perhaps over used expression in the aftermath of the financial crisis was the elephant in the room. Having experienced the near implosion of the world’s financial system, it was hardly surprising that economists and strategists continued to see major threats to longer-term stability that they thought were not being addressed. Six years on, while there are still issues that have yet to be fully resolved, the world has begun to normalise: the western banking system is more secure, economies are establishing more sustainable growth profiles, the threat of deflation seems to have been contained, and most governments’ finances are improving. Of course, there are still pinch points – the viability of Greece’s position in the eurozone being one – but the risk that one of these threats escalates and then causes systemic problems is far less.
However, there is one potential hazard that, should it become manifest, would represent a more significant threat to stability: inflation. While conventional economic analysis would have warned that injections of liquidity through quantitative easing (QE) on the scale undertaken by a range of central banks would have very appreciable inflationary consequences, to date there appear to have been none. Rather, most central banks have been more concerned about what were widely seen to be deflationary forces (wrongly, in our view). So, have we witnessed a miracle cure? Have policy makers engineered new tools that can be used without compunction during future crisis? Oh that this were true, but I very much doubt it is.
In fact, QE has already caused inflation, but not in areas covered by conventional price indices. When the US Federal Reserve and Bank of England first started to pump reserves into the monetary system, it was associated with a period of commodity price inflation. Were these simply coincidental, or was there causality from the former to the latter? I would argue that it was no mere happenstance and that QE was one of the factors that forced up, amongst others, the gold price and the oil price. More obviously, perhaps, QE has caused inflation in bond markets. While short-term interest rates have been exceptionally low throughout the post-recession period, would rates along the length of the yield curves of the major bond markets have fallen to the extent they have without QE? I very much doubt it. Elsewhere, it is possible to see inflationary trends probably linked to QE in land and property markets, and in art.
But in the places where, conventionally, you might have expected inflation to show through, it would seem there has been hardly a sign. In most countries, consumer price inflation has remained low to non-existent and wage increases have also remained very modest. So were the concerns that some of us voiced about the future inflationary implications of QE plain wrong? I doubt it. In fact, I doubt it to the extent that I am now becoming more not less concerned.
It always seemed likely that the ultimate consequences of QE would not become clear until growth had re-established a more normal path across a majority of developed economies. That has now happened in the US and the UK and is incipient in the eurozone. More broadly, following 2.5% in 2014, world growth is forecast to be 2.9% in 2015 and 3.2% in 2016. At the same time, there are signs that tightening labour markets are beginning to push up employment costs in the US, UK and Germany. There is, of course, no sign of this in headline consumer price indices. These are still reflecting the benefit of lower oil and food prices, but inflation is always a lagging indicator. Today’s low rates are telling you what was going on economics- and policy-wise one and two years ago.
My concern is that when, as expected, inflation picks up in western economies later this year, the upwards trend will be somewhat steeper than most economists are currently anticipating. And it may be this possibility that is just beginning to insinuate itself into bond markets.
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