The inflation merry-go-round
This post is a guest contribution by Spyros Andreopoulos & Joachim Fels of Morgan Stanley.
The last two to three months have seen the growth outlook for the global economy solidify and inflation return to the forefront of investors’ attention. Initially supported by successive rounds of QE, inflation expectations in the developed economies have recovered – in part with inflation itself. Inflation has climbed further above target in the UK, has moved above the ECB’s upper limit of slightly below 2% in the euro area, and is likely bottoming in the US. In addition, commodity prices have rallied, partly in response to the inflation/growth outlook (in the case of oil and some hard commodities) and partly in response to one-off supply disruptions (many agricultural commodities).
Markets: it’s business as usual for central banks. Bond markets have responded to the change in outlook by gradually shifting towards pricing in more hikes (in the short end) and lifting yields (in the belly of the curve and the long end), thus expecting central banks to respond to the outlook the way they have always done – by hiking rates pre-emptively, to nip any increase in inflation expectations in the bud. That is, markets seem to believe that central banks’ reaction functions have remained virtually unchanged.
The reaction function has changed: rational inaction. By contrast, we think that the major developed economies’ central banks’ reaction function has changed meaningfully with the crisis and the landscape it generated. We think, in the short term, that central banks’ strategy will be one of rational inaction, as a number of considerations will make it preferable to stay on hold:
• Financial stability concerns will make meaningful tightening difficult, as banking systems and consumer balance sheets are still fragile and highly indebted sovereigns live with the threat of bond market retaliation.
• Reduced visibility because the bumpy, below-par and brittle (BBB) economic recovery implies that it is better not to act. Put differently, given that inflation is the lesser evil – compared to the risk of a double-dip and/or deflation – we think that central banks will be inclined to act in a way that makes inflation, rather than deflation, more likely (see The Global Monetary Analyst: Better the Devil You Know, August 18, 2010).
• Moreover, central bankers have for some time repeated that they, and we, face an unusual level of ‘Knightian uncertainty’ – a type of uncertainty for which there is no underlying probability distribution. To be proactive, central bankers need a reasonable degree of certainty as to the economic forces at work and their eventual effect on inflation. Without such reasonable certainty, they may be condemned to being reactive and thus wait until the fog dissipates before they act in a meaningful manner.
In short, we believe that rational inaction means that the major central banks will be on hold for longer than markets expect, even in the face of heightened upside risks to inflation.
Fed, ECB and BoJ firmly on hold. In fact, we see neither the Fed nor the ECB nor the Bank of Japan hiking official interest rates this year. In Japan, our Bank of Japan watcher Takehiro Sato even expects further monetary accommodation through the enlargement of the asset purchase programme, which could happen as early as March 2011. In the US, where our team sees core inflation bottoming and gradually picking up later this year, the Fed will probably not renew the current bond purchase programme when it expires in June, but should keep rates on hold until early 2012 despite the solid average 4% GDP growth that our team is projecting through this year. And in the euro area, our ECB watcher Elga Bartsch thinks markets read too much into Trichet’s hawkish comments at the January press conference and expects the ECB to remain on hold throughout this year. Even though it is possible to separate interest rate policy (geared towards the maintenance of price stability) and liquidity policy (geared towards supporting the banking system and thus safeguarding the monetary transmission mechanism), we doubt that the ECB would dare to raise interest rates and thus funding costs for pressurised banks and sovereigns as long as the debt crisis lasts.
Bank of England between a rock and a hard place. Meanwhile, the Bank of England continues to be closer to a rate hike than the other three central banks we discuss. As today’s MPC minutes show, a second of the nine members, Martin Weale, joined Andrew Sentance in voting for a hike at the January meeting. However, since the meeting, 4Q GDP surprised massively on the downside earlier this week and Governor King in a speech last night made it clear that the BoE was willing to look through this year’s inflation spike provided that wages don’t accelerate in the course of this year. Our BoE watcher Melanie Baker thinks that inflation expectations will rise further this year and therefore continues to look for a first rate hike in August.
The rising tide that lifts all boats. But back to the big picture. During the Great Recession, developed economies’ central banks slashed rates aggressively; many of them – most notably the Fed, the ECB, the Bank of England and, to a lesser extent, the Bank of Japan – added unconventional measures to the mix when additional stimulus was needed. (Commodity prices, too, are likely to have received a lift from monetary policy since low real interest rates not only stimulated global growth, but also spurred inflation expectations.) The major central banks’ super-expansionary monetary policy stance was then imported by emerging economies such as China and others, whose central banks are reluctant to allow (too fast) an appreciation of their currencies against the dollar. Indeed, EM central banks continue to tread cautiously, even in the face of disappearing slack in the domestic economy and the presence of elevated food and energy quotes. Hence, they are unlikely to tighten appreciably in the near future (see The Global Monetary Analyst: “No, Minister”, January 19, 2011) – or allow their currencies to strengthen significantly.
Inflation re-export. Import prices in developed economies have already increased somewhat, and anecdotal evidence suggests that the prices for imports from China and other emerging economies are poised to increase further due to higher local inflation. In short, having imported inflation from developed economies through the monetary channel, the emerging economies are now re-exporting inflation to the developed economies through more expensive goods shipments.
Putting together the pieces: the global inflation merry-go-round. In turn, central banks in the major developed economies are likely to accommodate imported inflation arising from dearer commodities and other imports. They are, again, rationally inactive due to financial stability concerns, low visibility on the economic recovery and ‘Knightian uncertainty’.
However, this rational inactivity also makes it more likely that elevated imported inflation ultimately enters inflation expectations and ignites a wage-price spiral. To summarise the global inflation merry-go-round:
1. Super-expansionary monetary policy in the major developed economies is imported by emerging economies’ central banks through (US dollar) soft and hard pegs.
2. Having gained a toehold in EM, inflation is re-exported into developed economies through more expensive goods exports.
3. Rationally inactive central banks in developed economies accommodate this imported inflation, ultimately risking a domestic inflation take-off.
Note that this global inflation loop will remain operational until one of the two sides decides to normalise its monetary (or exchange rate) policy. Whether this will happen in time to prevent the global inflation merry-go-round from becoming an upward spiral remains to be seen.
The wrong kind of inflation? We have long been of the view that central banks in the major developed economies will likely generate, or at least acquiesce to, some inflation – given the backdrop of a shallow recovery, lower trend output growth in the medium term as well as high public and private debt levels (see The Global Monetary Analyst: Debtflation Temptation, March 31, 2010). Having inflation arise from external sources would, however, be the wrong kind of inflation. More expensive imports mean a reduction in disposable income for households and in profits for companies – hardly helping overlevered public and private sectors. However, with imported inflation pushing inflation expectations higher and central banks unwilling or unable to respond to the rise in non-core inflation, the chances are that domestic wages and inflation will also pick up eventually.
The global inflation merry-go-round has few takers among central banks in the smaller G10 economies. Here, the picture is as diverse as the economies themselves, though the common element is that public balance sheets are generally healthy. This removes one important constraint on central bank action. In addition, commodity producers benefit from the shift in commodity prices, which lifts domestic production and income. For that very reason, they certainly don’t face the problem of having the wrong kind of inflation – any price pressures will emerge from an overheating domestic economy.
Australia: Our RBA watcher Gerard Minack expects Australia’s central bank to hike once more by the end of 1Q11 but then to stay on hold for the remainder of the year. The hike is earlier than the market expects, although the terminal rate of 5.00% is roughly in line with market expectations.
Canada: Yilin Nie and David Cho think that the BoC is comfortable with more tightening; they are looking for an above-market terminal rate of 2.00% for this year.
New Zealand: Manoj Pradhan expects the RBNZ to lift rates again in the second quarter and expects a total of 75bp by year-end. His year-end target of 3.75% is somewhat higher than the market expects.
Norway: Spyros Andreopoulos thinks Norges Bank will resume its hiking cycle at the May meeting; this is somewhat earlier than market expectations, though our year-end target of 2.50% for the main policy rate is in line with market expectations. We see risks as skewed towards a later hike.
Switzerland: The SNB is unlikely to take its focus off the EURCHF exchange rate, in our view; we think that its monetary policy will shadow the ECB, not hiking before 1Q12. The market seems to be pricing about one hike by the end of the year.
Sweden: Sweden’s impressive economic performance has Riksbank watcher Elga Bartsch looking for 125bp of hikes for a terminal rate of 2.50% by the end of the year. Although the market has gradually moved to price in more hikes, it is still below our own expectation.
Source: Spyros Andreopoulos & Joachim Fels of Morgan Stanley, January 28, 2011.
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