Fear leads inflation expectations lower

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By Cees Bruggemans, Chief Economist of FNB.

It looks like there were ultimately two moments of truth in recent times. The moment of panic crisis (back in late 2008), and again very recently once past the initial recovery bounce when faced by the sustained recovery question.

It turns out that not every disturbed soul switched back on the juices yet once past the crisis moment.

Indeed, deep questions lingered.

About government fiscal sustainability (them not being able to borrow excessively indefinitely).

About central bank accommodation (would it ultimately prove inflationary?).

About housing markets (some still imploding?).

About banks (still fragile). About households (still deleveraging). About businesses (still in shock and preferring to lay off labour and emphasize productivity enhancement and earning restoration). About equity markets (how much downside?).

Leaving only cash and bond markets (how much upside?).

Financial markets act on perceptions. And the times apparently remain suspicious and anxious.

With growth slowing nearly everywhere (except Germany, for now) once past the inventory correction and fiscal boosts, and with all those questions remaining as listed above, there remained many who preferred safe haven cash or near cash (US, UK and German government bonds).

Real bond yields (and inflation expectations) collapsed during the 4Q2008 crisis, rebounded gratefully during 2009 to pre-crisis levels, but since early 2010 a renewed relapse in real bond yields and inflation expectations appears to be underway, if more slow motion than in 2008.

It needs to be seriously asked: is this for real?

The renewed subsidence of leading government bond yields, the steady downward drift in rich world inflation and the renewed drop-off in such real bond yields are all factual and very real.

Does it also signify a drop in inflation expectations, from preferred targeted levels to dangerously low cliffs separating us from deflation?

There is at least the hint that increasing numbers people fear this tendency. And once psychologically committed to a thought, is it but a small step to act on the presumption and making it come true in a self-fulfilling reinforcement.

But will Western growth genuinely double-dip, will China really shock our senses shortly, will inflation in many countries really cease and topple over into deflation, will asset markets other than fixed income really suffer decline as a consequence?

Only time will show up the real answers to these many propositions. Meanwhile global investors are acting and they are not piling into commodities (except precious metals, a bad sign), equities or real estate. Instead, already very dear bonds (2% nominal return for ten years, anyone?) and nil-return cash are the darling investment vehicles of choice.

To put it mildly, these are very insistent and disturbing tendencies, as much fearing the apparent drift of things as the policy solutions on offer.

For not everyone is apparently equally happy with what central banks may still try next. As UBS senior advisor George Magnus put it last Thursday in the FT, “print more money and be damned, don’t print more and invite chaos”.

And that is from someone apparently favouring more printing. It shows the uncharted territory we seem to have drifted into.

“You want me to do what” screamed the body as the mind of the determined bungee-jumper proposed to overrule all opposition and JUMP.

You smile? Good. It means all is not lost, yet. If you were to only grimly turn the page it would mean the body had won (no jumping now or ever).

Still, the question needs to be asked. Is growth in the rich world really seriously dwindling lower, with the East consolidating as well and therefore not preventing the drift towards the recession cliffs?

And if so, are the anchors holding inflation expectations really seriously drifting, with deflation imminent?

For the leading central banks don’t want to act on just any whim. This now requires split second timing and precision. The global system either genuinely needs more support, or all we hearing are the ravings of liquidity addicted money junkies wanting yet more, and more, fixes just to keep them going mentally.

If the growth and inflation condition is serious, but not fatal (meaning low growth and very low inflation but no tipping points being crossed), there is no business in providing yet more liquidity support.

Led them swim and sink as comes naturally, in the process getting weaned off a dangerous habit, WITHOUT actually losing either the growth or inflation plot.

Certainly ECB President Trichet, and aspirant-hopeful Weber, continue playfully to hint that Europe can start its monetary normalization process sometime before mid-2011, not all that different from the fiscal timetable.

And apparently seven of the seventeen FOMC members in the US voted against more monetary support being provided at the 10 August Fed meeting, not really wanting to prevent the slow shrinking of the Fed’s balance sheet as maturing mortgage bonds are repaid.

But crucially ten FOMC members voted in favour and chairman Bernanke made that full throttle ahead. At least, that was the market’s interpretation and anticipation, with much hanging on his Jackson Hole (Wyoming) speech last Friday.

And he didn’t disappoint. He continued to talk a modest game, preferring to believe things are holding together, but with the hint that if they don’t there will be policy aggression.

It made markets already feel much better all round, perking up on the noise flow. But will it outlast the summer lull? The moment of truth will be late September, with the next FOMC meeting coinciding with all the boys and girls being back in harness and roaring to go.

But if growth and inflation performances are bad enough as they are (never mind double-dip recessions and deflation), the resource slack (unemployment) in the US is really unbearable, and a mature populist democracy won’t stand for such nonsense for very long, something needs to be done for otherwise it could lead to unwanted social and political dislocations as well.

And that could only create more negative feedback loops, or so the Fed might reason.

With global bond yields remaining in full retreat, with growth disappointing, inflation and its apparent expectations drifting yet lower, and many central banks becoming ever more cautious (for whatever comes next?), the proactive modern Fed is unlikely to just drift.

Bernanke will not suffer even the risk of deflation.

In the words of George Magnus already quoted, if you are going to be damned anyway, you might as well be damned for the right reasons.

In other words, for actively finding a way out of this dangerous impasse, and escaping the maze in better fettle than apparently expected by many.

This suggests more US quantitative easing is coming (Treasury bond buying, once again further expanding the Fed’s balance sheet).

Long bond yields can yet go lower worldwide. More capital can flow to still higher yielding peripheral areas and the Dollar weaken (probably part of the Bernanke calculation) despite global risk appetite potentially being under assault from so much anxiety.

Though this may hardly be a smooth consolidation in coming months/quarters, it suggests yet higher precious metal prices (fear based) and yet more foreign capital flows into our still richly yielding bonds.

It presumably means the Rand firming yet more, unless by some miracle the strapless bra upholding the Dollar (risk driven) keeps overcoming gravity and stays in place.

Either way, South Africa will be importing yet more global disinflation (and trade price deflation) in a direct way (as these conditions now rule nearly everywhere) while a further firming of the Rand would indirectly bolster this process further.

If non-precious commodity prices (oil, food) respond more to the fearful growth expectations than any Dollar weakness, subsiding in turn, our inflation picture can get yet even more suppressed.

This would suggest a growth and inflation undershoot more than currently still discounted.

Thank goodness for small mercies. With our repo rate still sitting at 6.5%, our SARB will have plenty of leeway to respond to coming events.

Not like Canute trying the impossible, but at least supporting our domestic stability by judicious use of the policy lever still available to it.

It would seem our interest rates haven’t yet reached their lowest cyclical point.

Just how low these can still fall, and how long they will still linger there will probably take us a considerable time finding out.

Source: Cees Bruggemans, First National Bank, August 30, 2010.

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