Inflation

A few months ago, the Federal Reserve seemed determined, at long last, to normalise monetary policy in the US. In fact, it still seems to be set on that course. The FOMC has indicated that it intends to raise rates in June by a further 0.25 per cent, and they also seem ready to announce a plan to shrink the central bank balance sheet in September.

But there is now a fly in the Fed’s ointment. The last two monthly releases for consumer price inflation have been much weaker than anyone expected. Although the FOMC was fairly dismissive of the first of these announcements – saying in the minutes of its May meeting that it was probably caused by temporary or idiosynchratic factors – it is not yet known whether they have continued to ignore the second set of weak CPI data in April. The two months together have left core CPI inflation 0.4 percentage points lower than expected.

When the PCE deflator is released next Tuesday, it will probably show the 12-month core inflation rate at 1.5 per cent in April, the lowest figure since the end of 2015. The FOMC’s reaction to this incoming news will depend on their reading of the underlying causes of low inflation, which are highly uncertain. But the markets have already decided that they will take the evidence seriously enough to abort their programme of rate rises after the planned June increase. Read more

The global reflation regime that has been dominant in the financial markets for much of the past 12 months has paused in recent weeks. Many commentators, including James Macintosh at the Wall Street Journal and the FT’s Gillian Tett, have suggested that this pause in the markets is giving ominous signals about the health of global economic activity. Concerns have been expressed about the strength of official US GDP data in 2017 Q1, and there have been unexpectedly low readings for core inflation in several economies.

This shift in mood is probably too pessimistic. The change in market behaviour has so far been small, relative to the large rise in equities and the decline in bond prices seen since world activity bottomed in February 2016. Furthermore, while there has been a modest slowdown in US activity indicators since March, the growth rate remains well above trend, and the official GDP numbers are likely to be much stronger in 2017 Q2 and Q3.

However, there are legitimate concerns about the ability of the Trump administration to deliver the large fiscal stimulus that had been expected. These concerns need to be addressed in the announcements on tax policy that are expected imminently. Read more

A year ago, Lawrence Summers’ perceptive warnings about the possibility of secular stagnation in the world economy were dominating global markets. China, Japan and the Eurozone were in deflation, and the US was being dragged into the mess by the rising dollar. Global recession risks were elevated, and commodity prices continued to fall. Fixed investment had slumped. Productivity growth and demographic growth looked to be increasingly anemic everywhere.

Estimates of the equilibrium real interest rate in many economies were being marked down. It seemed possible that the world economy would fall into a “Japanese trap”, in which nominal interest rates would be permanently stuck at the zero lower bound, and would therefore not be able to fall enough to stimulate economic activity.

Just when the sky seemed to be at its darkest, the outlook suddenly began to improve. Global reflation replaced secular stagnation as the theme that dominated investor psychology, especially after Donald Trump’s election in November. Why has secular stagnation lost its mass appeal, and has it disappeared forever? Was it all a case of crying wolf? Read more

In mid 2016, the global economy embarked on a regime of reflation that has been dominating market behaviour ever since then. This has constituted a simultaneous rise in real output growth, along with a rebound in inflation as commodity prices have recovered from their 2014-15 slump.

The result has been a sharp increase in nominal GDP growth in most of the major economies. As the secular stagnation theme has lost its potency for investors, a decline in the perceived risk of outright deflation has triggered a rise in breakeven inflation expectations in bond markets everywhere.

One of the most important questions for 2017 is whether this bout of reflation will continue. My answer, based partly on the latest results from the Fulcrum nowcast and inflation models (see first graph), is that it will continue, at least compared to the sluggish rates of increase in nominal GDP since the Great Financial Crash.

However, the nature of the reflation theme is changing. The term “reflation” does not necessarily imply that global inflation, or inflation expectations, will continue to rise very much from here.

A likely pattern in 2017 is that there will be upgrades in consensus forecasts for real output growth, but inflation will stabilise, and will not threaten to break above central bank targets in most advanced economies.

Equities and other risk assets would probably view this as a healthy mix of output and inflation components of national income, while bond markets would probably exhibit a stabilisation in breakeven inflation expectations, with real yields rising a bit. Read more

The financial markets have begun to wake up to the fact that the Republican reforms to US corporate taxation will probably include important new “border adjustments” to the definitions of company revenues and costs. The basic idea is that US should shift to a “territorial” system, with corporations being taxed only on revenues and costs incurred within the US itself, and not on their worldwide aggregates, which is the principle behind the present system. [1]

A border tax was not explicitly part of the Trump platform before the Presidential Election. It was, however, included in the tax plan published last year by Paul Ryan in the House of Representatives, and Mr Trump has recently tweeted that companies that do not “make in USA” can expect to “pay big border tax”. That might be compatible with the Ryan plan, though it also might not be.

Although most other countries already operate “territorial” systems, the Republican plan includes other features that would make the new tax regime operate like a tariff on imports into the US, combined with a subsidy on many exports from the US, a combination that would have profound international economic consequences.

This is not just an obscure change to the details of America’s corporate tax code. It would be seen by trading partners as a protectionist measure that could disrupt world trade.

The direct effects of a border tax adjustment to the US corporate tax regime would be likely to raise American inflation, cut imports, boost exports and raise tax revenue, possibly by over $1.2 trillion over a decade. However, it would also raise the dollar’s exchange rate, which could offset or cancel out some of these other effects.

The impact on real GDP and employment would depend on how these effects panned out, and how the Federal Reserve reacted to the increase in inflation. It cannot be assumed that the effects would be beneficial. Recent estimates by Michael Gapen and Rob Martin at Barclays Capital suggest that the first year effects would be to raise US inflation by about 0.5-1 per cent, and to reduce real GDP by 1.0-1.5 per cent.

Given these economic effects, it is very doubtful whether this form of border tax, taken in isolation, would be good for the overall equity market, though other planned reforms to the corporate tax regime (including lower marginal tax rates, and full deduction of capital spending in the first year) certainly would be. Read more

A year ago, there was a pervasive mood of gloom among economists and investors about prospects for the global economy in 2016. China was in the doldrums, and fears of a sharp renminbi devaluation were rife. The oil shock had caused major reductions in capital spending in the energy sector, and consumers seemed reluctant to spend the large gains they were enjoying in real household incomes.

Deflation risks dominated the bond markets in Japan and the Eurozone. In the US, the Federal Reserve seemed determined to “normalise” interest rates, despite the rising dollar and the weakness in foreign economies.

At the turn of the year, there were forecasts of global recession in 2016. At the low point for activity and risk assets in 2016 Q1, the global growth rate (according to the Fulcrum “nowcasts”) had dipped to about 2 per cent, compared to a trend growth rate of 4 per cent. It was a bleak period. The dominant regime in financial markets was clearly one of rising risk of deflation.

Since then, however, there has been a marked rebound in global activity, and in recent weeks this has become surprisingly strong, at least by the modest standards seen hitherto in the post-shock economic recovery. According to the latest nowcasts, the growth rate in global activity is now estimated to be 4.4 per cent, compared to a low point of 2.2 per cent reached in March.

The latest growth estimate is the highest reported by the nowcast models since April, 2011 – before the euro crisis and the China slow-down hit global activity very hard. This relatively upbeat take on the current state is supported by alternative data sources. For example, the Goldman Sachs Global Leading Indicator has just reached its highest point since December, 2010.

The uptick in global activity growth has, of course, been accompanied by a rise in headline inflation rates in almost all major economies. Recently, I argued that this jump in inflation was still “weak and patchy”, and almost entirely due to the partial recovery in oil prices, which has been taken further this week by the market reaction to the OPEC decision to reduce oil production.

However, the bond markets have taken the reflation trade increasingly seriously, in part because of the assumed shift towards fiscal easing after the election of Donald Trump in the US. Although the case for a rise in core inflation in 2017 (as opposed to headline inflation) is far from convincing, the recent rebound in global activity may well give the “reflation trade” a further leg upwards.

Morgan Stanley says that investors have stopped asking “is reflation happening?” and instead they are now asking “will it prove sustainable?” It is easy to be sceptical about this. We could be observing nothing more than another short term spike in activity. But, for the moment, the newsflow is clearly improving in a manner that has not hitherto been seen during the faltering “recovery” from the Great Financial Crash. (Full details of the monthly nowcasts can be found here.) Read more

The global markets remained in reflationary mode for much of last week, a regime that has now persisted for many months. Led by the US, bond yields have been rising, mainly because inflation expectations are on the increase. Risk assets have been performing adequately, with the exception of the emerging markets.

This reflationary regime has been driven by much stronger global economic activity since mid-2016, and latterly by a belief that Donald Trump’s election victory will lead to US fiscal easing, along with the possibility of the “politicisation” of the Federal Reserve, implying overly accommodative monetary policy.

There are various ways in which this regime could end. The world economy could suddenly go back to sleep, as it has on many occasions since 2009. The US fiscal easing could become bogged down in the Washington “swamp”. Or the Fed could become unexpectedly hawkish, stamping on the first signs of inflationary growth in the American economy. This last risk is probably under-estimated, and is worth considering in detail. Read more

The response of the financial markets to the US election result has been almost as contradictory as the rabble rousing campaign of the President-elect himself. Unmitigated gloom in the hours after the Trump victory was swiftly followed by a euphoric atmosphere in US markets.

Investors are apparently assuming that the new administration will usher in a mix of fiscal reflation, prudent monetary policy, deregulation and tax cuts that will prove very good for the American economy. Trade controls are seen as damaging the emerging economies, but not the US. A steeper yield curve is seen as reflecting a “better” mix between fiscal and monetary policy.

With one very graceful acceptance speech, Donald Trump has suddenly morphed into Ronald Reagan in the markets’ consciousness. Read more

The great global disinflation in the advanced economies started in 1982, flattened in the 1990s and 2000s, and then nosedived towards deflation as commodity prices collapsed in 2014-15. For much of that final period, deflation fears dominated global bond markets and, to a lesser extent, equities and other risk assets. But there have been signs during 2016 that markets have edged away from a regime of “deflation dominance”, and we have seen partial signs of reflation.

It would be a bold call to claim that the great disinflation of the last three decades is now beginning to reverse. I am certainly not making that call. However, headline inflation is now rising towards the rates recorded before the oil price crash. There are signs that the risk of outright deflation is falling and, in some parts of the developed world, core inflation has edged higher. Read more

As investors anxiously await the key monetary policy decisions from the Federal Reserve and the Bank of Japan next week, there have been signs that the powerful rally in bond markets, unleashed last year by the threat of global deflation, may be starting to reverse. There has been talk of a major bond tantrum, similar to the one that followed Ben Bernanke’s tapering of bond purchases in 2013.

This time, however, the Fed seems unlikely to be at the centre of the tantrum. Even if the FOMC surprises the market by raising US interest rates by 25 basis points next week, this will probably be tempered by another reduction in its expected path for rates in the medium term.

Instead, the Bank of Japan has become the centre of global market attention. The results of its comprehensive review of monetary policy, to be announced next week, are shrouded in uncertainty. So far this year, both the content and the communication of the monetary announcements by BoJ governor Haruhiko Kuroda have been less than impressive, and the market’s response has been repeatedly in the opposite direction to that intended by the central bank.

As a result, the inflation credibility of the BoJ has sunk to a new low, and the policy board badly needs to restore confidence in the 2 per cent inflation target. But the board is reported to be split, and the direction of policy is unclear. With the JGB market now having a major impact on yields in the US, that could be the recipe for an accident in the global bond market. Read more

Ever since the crash of 2008, the global financial markets have been subject to prolonged periods in which their behaviour has been dominated by a single, over-arching economic regime, often determined by the stance monetary policy. When these regimes have changed, the behaviour of the main asset classes (equities, bonds, commodities and currencies) has been drastically affected, and individual asset prices within each class have also had to fit into the overall macro pattern. For asset managers of all types, it is therefore important to understand the nature of the regime that applies at any given time.

This is not easy to do, even in retrospect. There will always be inconsistencies in asset performance which cause confusion and require interpretation. Nevertheless, it is an exercise which is worth undertaking, because it can bring a semblance of order to the apparent chaos of asset markets.

Two main regimes have been in place in the asset markets of developed economies since 2012. (The emerging markets also fit the pattern, with some slight differences.)

These regimes are, first, the period in which quantitative easing was the dominant factor, from 2012 to mid 2015; and, second, the period in which deflation risk has been the dominant factor, from mid 2015 to now.

It is possible that the markets are now exiting the period of deflation dominance, and they may even be entering a new regime of reflation dominance, though this is still far from certain. Secular stagnation is a powerful force that will be hard to shake off. But if that did happen, the pattern of asset price performance would change substantially compared to the recent past. Read more

A few months ago, this blog commented that a rise in inflation in the advanced economies early in 2016 was “almost certain”. Thank goodness for the word “almost”. Since then, oil prices have plumbed new depths, and the markets have remained obsessed with fears about deflation.

The case for higher inflation in 2016 rested on the fact that the impact of energy on headline consumer price inflation would change direction when oil prices stabilised. This “inevitable” arithmetic effect has been delayed by the slump in oil prices in January, but it should manifest itself in the near future.

The key question, though, is whether this automatic rise in headline inflation presages a more important turning point for underlying inflation in the advanced economies – a turning point that has been wrongly predicted for several years now.

The answer is that there are some tentative signs of a slow rise in underlying inflation in the US, where price increases have been higher than expected in recent months. In contrast, inflation rates in the Eurozone and Japan have surprised on the low side. There, fears of “secular stagnation”, leading to deflation, still seem all too real. Read more

As Paul Krugman pointed out a year ago, a sharp difference of views about US monetary policy has developed between two camps of Keynesians who normally agree about almost everything.

What makes this interesting is that, in this division of opinion, the fault line often seems to be determined by the professional location of the economists concerned. Those outside the Federal Reserve (eg Lawrence Summers, Paul Krugman, Brad DeLong) tend to adopt a strongly dovish view, while those inside the central bank (eg Janet Yellen, Stanley Fischer, William Dudley, John Williams) have lately taken a more hawkish line about the need to “normalise” the level of interest rates [1].

My colleague David Blake suggested that this blog should carry a Galilean “Dialogue” between representatives of the two camps. Galileo is unavailable this week, but here goes. Read more

Ever since the crash in 2008, the central banks in the advanced economies have had but one obsession — how to set monetary policy to ensure the maximum growth rate in aggregate demand. Interest rates at the zero lower bound, followed by a massive increase in their balance sheets, was the answer they conjured up.

Now, those central banks contemplating an exit from these policies, primarily the US Federal Reserve and the Bank of England, are turning their attention to the supply side of their economies. When, they are asking, will output reach the ceiling imposed by the supply potential of the economy?

The Bank of England has been in the lead here, with the Monetary Policy Committee recently conducting a special study of the supply side in the UK. Its conclusion was that gross domestic product is now only 0.5 per cent below potential, which implies that tighter monetary policy will soon be needed if GDP growth remains above potential for much longer.

In the US, the Fed has been much less specific than that, but the unemployment rate has now fallen very close to its estimate of the natural rate (5.0-5.2 per cent). Sven Jari Stehn of Goldman Sachs has used the Fed staffers’ supply side models to calculate that their implied estimate of the US output gap may be only 0.6 per cent, not far from the UK figure.

If the UK and US central banks were to act on these calculations, the implication would be that they no longer hold out much hope that they can ever regain the loss in potential output that has occurred in the past decade, relative to previous trends. That would be a massive admission, with an enormous implied sacrifice in future output levels if they are wrong. It would also be very worrying for financial assets, since it would draw the market’s attention to a downgrade in the Fed’s estimation of the long-run path for GDP. Read more

The leading central banks in the developed economies have, of course, been the main actors underpinning the global bull market in risk assets since 2009. For long periods their stance has been unequivocally dovish as they have deliberately tried to strengthen an anaemic global economic recovery by boosting asset prices.

In the past week, we have had major statements of intent from Janet Yellen, the new US Federal Reserve chairwoman; from the European Central Bank; and from the Bank of England. After multiple hours of fuzzy guidance about forward guidance, the clarity of previous years about the global policy stance has become much more murky. Central banks are no longer as obviously friendly to risk assets as they once were – but they have not become outright enemies, and they are unlikely to do so while they are concerned that price and wage inflation will remain too low for a protracted period.

It is now quite difficult to generalise about what central bankers think. However, a few of the necessary pieces of the jigsaw puzzle slotted into place in the past week. Read more

The governing council of the European Central Bank meets on Thursday amid rising expectations in the market that it will signal another easing in monetary policy, either in February or March. Most ECB watchers now expect the council to cut the refinance rate by around 15 basis points before quarter end (from 0.25 per cent to 0.10 per cent), and some expect the deposit rate to be reduced into negative territory for the first time. This action would be in response to recent volatility in money market rates, and an unexpectedly low inflation rate of 0.7 per cent for the euro area in January.

If the ECB was to follow this course of action in the next couple of months, it would represent another relatively minor adjustment in its policy stance in response to surprisingly low inflation data. It is still thinking in terms of incremental changes in policy, rather than anything more dramatic. This, of course, follows from the fact that the ECB has a pessimistic view of the growth in potential output since 2008, implying that the output gap is fairly small, and that inflation in the medium term will gradually return to the target of “below but close to” 2 per cent.

This view is, however, being increasingly challenged by the data. Some forecasters now see the 12-month inflation rate falling to only 0.5 per cent in the spring, depending on the behaviour of oil prices. More importantly, core inflation also continues to drop. After the next round of interest rate cuts, the central bank will genuinely be at the zero lower bound for the first time ever. The ECB will therefore face a major problem if the inflation data confound again, and head towards zero. Read more

In recent months, inflation has again reared its head as a problem in the developed economies. But this is not because it is too high. In most countries, headline CPI inflation has been falling significantly since the end of 2011, and it has now dropped to less than 1 per cent in both the US and the euro area.

Furthermore, the pervasive decline in headline inflation has been accompanied by a similar decline in core inflation rates, which are also hovering at worryingly low levels in most countries. In fact, out of the 25 developed economies that publish regular data on Haver Analytics, only Iceland is currently experiencing an inflation rate that could be considered markedly too high by any of these measures. Read more

The volatility in financial markets since Mr Bernanke gave evidence to Congress yesterday is a not-so-gentle reminder of what might happen when the Fed eventually begins to withdraw monetary accommodation. The Chairman’s warning that the FOMC might reduce the pace of its asset purchases “in the next few meetings” has clearly spooked the markets, especially those (like Japanese equities) where bullish positions had become very crowded.

The Fed’s main message at present is that it will “increase or reduce the pace of its asset purchases…as the outlook for the labor market or inflation changes”. This seems deliberately designed to inject some uncertainty into market psychology, and thereby prevent an excessive risk taking. Mr Bernanke said that he takes the risk to financial stability “very seriously”.

But the overall tone of the Chairman’s written evidence yesterday strongly suggested that the Fed is still a long way from contemplating any significant change in monetary policy. After all, tapering QE would only imply that the pace at which policy is being eased is being reduced. An outright tightening of policy still seems to be several years away. Read more

After more than 20 years, and 82 issues, Sir Mervyn King has delivered his last Inflation Report. The transparency and rationality of this innovation has been one of Britain’s most important gifts to the world in recent times, even if the UK has not actually been very good at controlling inflation itself since 2008. As its main architect and, in his own words, the UK’s “consistent monetary referee”, Sir Mervyn deserves great credit. I hope that, in retirement, he will receive it.

The economic message of today’s report is a familiar one. Inflation has been revised down so that it is shown to hit the 2 per cent target in two years’ time, and real GDP is forecast to recover gradually. Similar forecasts have proven too optimistic in the past, but this time there are clear indications that the Bank will be introducing new forms of policy easing in the next few months, which may underpin the economic recovery.

Following the astonishing arrival of Governor Kuroda in Japan, Mr Carney must be sorely tempted to follow suit in trying to jolt UK economic expectations towards a new equilibrium. He is likely to get plenty of encouragement in this from the chancellor, who emphasised in the Budget that “monetary activism” is a core part of his overall economic strategy.

In fact, Mr Osborne has asked the Bank to focus in the August Inflation Report on how the UK might adopt forward policy guidance, with thresholds, following the example of what the Fed did (successfully) last December. This is an unusually specific request from the Treasury, and even Sir Mervyn seemed sympathetic to this approach today.

In the context of high British inflation, there are serious impediments to repeating the fireworks unleashed by the BoJ, but some progress can be made, Fed-style. What exactly can we expect? Read more

Kuroda gives first press conference as governor of BoJThe package of quantitative easing announced today by the new regime at the Bank of Japan is one of the largest monetary injections ever announced by the central bank of a major developed economy. The only rival for that crown is the emergency easing in monetary policy which took place in most economies in late 2008. But today’s BoJ action has not been driven by any short-term emergency. It represents a deliberate change in philosophy, and a complete abandonment of everything that the Bank of Japan has said about monetary policy in the past two decades. Those who believe in quantitative easing certainly have their experiment, writ large in Tokyo.

In effect the new governor, Haruhiko Kuroda, has imported into Japan the whole of the Federal Reserve’s post-Lehman balance sheet strategy, and he will implement it in under two years, instead of the five years or more taken by the Fed. The doubling in the Japanese monetary base over a period of 21 months is in itself remarkable. Taken together with the extension of the duration of bonds purchased from less than 3 years to an average of 7 years, the injection becomes of historic proportions.

The new strategy brings, for the first time, a real prospect of breaking the deflationary psyche which has plagued Japan for so long. But it also brings risks that the strategy might work too well, with inflation expectations unhinging the bond market. Mr Kuroda is trying to pull off a difficult trick, which is “to drastically change the expectations of markets and economic entities”, and to do so in a very particular way. Read more