Kames fund manager James Lynch takes a quick look at today’s US CPI release and why there are good fundamental reasons we can expect higher inflation.
In a remote north-west corner of Scotland there is an island in the middle of a loch called St Maree. On it are the remains of a chapel and a holy tree, believed to be around 1,300 years old. Legend had it that if you rowed around the island twice, submerged yourself in the water and made an offering to the tree, you would cure yourself from lunacy. Many people made this offering over the years, and the tree was filled with hammered-in coins.
Even in today’s more enlightened world, we see versions of this money tree – be it a political party making unfunded promises, or offering money to cure a problem that money can’t solve.
Regarding the latter, central banks globally have offered money to institutions to cure the problem of low or no inflation. They may not directly give the money away (although you could argue that the ECB’s Long-Term Refinancing Operation does just that), but central banks have been buying bonds that institutions hold, both sovereigns and corporates. Through different channels this money was meant to stimulate lending, boost growth and, importantly, lift inflation.
Years on, global GDP looks fine, but inflation has not taken off, while at the same time we have significant side effects – not least inflated asset prices in bond markets.
The ECB is set to continue its QE programme into 2018; yet inflation has not returned to target and is unlikely to over the bank’s three-year horizon. Which leads me to the popular quote: “the definition of insanity is doing the same thing over and over again expecting a different result”.
On the island of St Maree there were too many offerings to the tree – eventually it died of copper poisoning. Is this what we can expect from the central bank money tree?
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The Bank of England (BoE) today made a not-so-subtle attempt at getting the market ready for an imminent interest rate rise. In the minutes of today’s 7-2 vote it was noted that “a majority of MPC members judge that…. some withdrawal of monetary stimulus is likely to be appropriate over the coming months….”. From previous statements the BoE Chief Economist Andy Haldane has made, the rate rise would be more about removing stimulus added in the wake of the Brexit vote rather than the start of a hiking cycle.
That is the communication tightrope they will have to walk going into the November Quarterly Inflation Report. Do they go down the “one and done” Haldane view? Or do they have the confidence in the economy (and more to the point that wages will finally rise) that means a full-blown rate hiking cycle in the coming months? Of course “coming months” could include February 2018, but either way it is the most explicit the Bank can get in paving the way for a decision.
What should be certain is that we will all be pouring over the MPC members’ speeches in the run up to November. Given that this could be the first increase for 10 years, the Bank will want the market to be fully prepared.
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The Governor of the Bank of England (BoE) has just said, as it released its Quarterly Inflation Report, that it expects to reduce stimulus more than the market is currently pricing.
Yet the bond market rallies.
The BoE reduced growth and wage expectations for next year, while still predicting above-target inflation three years out, and keeping alive the prospect for a rate hike. One way to square that circle is if it has lowered its assumptions about the potential growth of the economy – meaning that even if we beat trend growth just a little bit, we will be reducing slack in the economy, enough to warrant a reduction in stimulus. In other words, the UK has an even lower bar to beat. This could be seen to be hawkish.
Yet the first reaction of the market was one of scepticism, pushing out rate hike expectations even further. The Monetary Policy Committee (MPC) may now face a communication problem. It has to convince the market that it is serious about raising interest rates, after the hawkish noises heard earlier in the summer were not followed through in today’s vote (as per our earlier article, http://bondtalk.co.uk/macro/monetary-policy-soft-or-hard-approach-not-just-a-political-dilemma/ Haldane could have made it 5-3, yet the vote was 6-2).
Perhaps the best way for the MPC to communicate that it wants the market to price higher interest rates is to actually deliver and reduce the stimulus put in place last August – that will certainly get the market’s attention.
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Following the financial crisis our main central banks (to keep it simple let’s stick with ECB, BoE and the Fed) needed to get real interest rates (the difference between the nominal interest rate minus inflation) down. This is the normal playbook that a Central Bank should use and even more so after the global financial crisis. They needed to get money moving again not only to the real economy but also within the financial system which was not only broken but was on the brink of collapse and without too much exaggeration could have brought down capitalism with it.
But the conundrum coming out of the financial crisis was why inflation did not significantly rebound given the spectacular amount of stimulus in place. As inflation has remained low and even went negative again across the developed world in 2015 the Central Banks kept reducing interest rates and buying bonds – the ECB is still negative and is still increasing the balance sheet to keep these real rates as low as they can without causing too many negative side effects.
The reasons why inflation has been lower than you would have expected will probably become a popular dissertation topic amongst Economic students in the coming years. I imagine these papers will cover globalisation, online shopping & tech, demographics and the breakdown of the Philips curve to name but a few. Also I don’t think we should ignore the impact of Shale and the fall in commodity prices over this period.
These are mainly structural changes, but monetary policy is a cyclical tool – and here is the problem. We have policy at what is without doubt emergency levels which has not had the desired effect (apart from one time impacts from falls in the currency) and what it has caused is inflation in asset prices – housing, equities and bonds, not in the real economy and certainly not in wages (which you could argue are structural issues).
Should Central Banks perhaps place more emphasis on growth, employment and wages (which the BoE have explicitly targeted post-Brexit) rather than inflation? Or should that be the job of the Government? Is that the pertinent question – have our governments collectively failed to adapt to this changing world?
All of which leaves monetary policy in a tricky place. There are strong arguments coming to the fore that the emergency levels of accommodation should now be removed, not because inflation is becoming rampant, but because perhaps it was an ineffective tool against the structural challenges we face; or maybe Central Banks just need rates to get high enough so that they can cut them again in preparation for the next down turn (confidence is also a tool). The Fed have raised rates 4 times since December 2015, the ECB will be running out of bonds very soon and there are signs the BoE are becoming twitchy (3 out of 8 voted for a rate hike this week).
For all their failings, at least the Central Banks tried to do something. They were trying to create an environment where ultra-cheap money could foster growth and self-sustained inflation could flourish. Unfortunately if you were not in those assets that have gone up then all it has done is create greater wealth inequality; and while fiscal spending has been absent it is no wonder that we are starting to see political unrest. For example, it seems inevitable in the UK that the current government will have to provide their own stimulus to the population, where nothing is off the table, or the people will vote for a party that will.
The inflation surge as evidenced by the TIPS market (US Government Treasury Inflation Protected Securities) that started around September ’16 has taken a bit of pause and has actually has started to reverse.
Undoubtedly there were some Trump effects to the inflation rally in the US, which in turn lifted markets globally, but the path to higher inflation prints and decent economic conditions was already in place before the November Presidential election. The election just removed some of the downside tail risks.
However, since inauguration day on 20th January 2017, the level of inflation break-evens in the US are now lower. Some of the enthusiasm based on expectations of a relatively quick implementation of tax reform and infrastructure spending, perhaps financed by either Border Taxes or increased borrowing, has fallen away. Healthcare reform has highlighted how difficult it will be for President Trump to implement changes. Another issue for the inflation market is that we may already have reached the high in the US inflation print for this year, 2.7% CPI recorded in February, which does have a psychological impact.
So where does the market go from here? Expectations are now low for reforms and the medium to long term picture has not changed. The “America First” policy is still alive but it is proving not to be progressing as fast as the market would like. The fundamentals are solid, core inflation in the US is 2.2% (excluding energy and food) and 5 year inflation is priced at 1.85% according the market, so valuations are compelling. However, the pause in the market seems correct as we look for the next catalyst.
The Bank of England has kept its policy rate unchanged at 0.25% and has voted to keep the stock of purchases unchanged by 9-0. This was expected by the market.
The important conundrum for the BoE is if the economy continues to be more resilient than the Banks’ own forecasts, what is its reaction function to above-target inflation?
Within the Quarterly Inflation Report it did indeed improve its outlook for UK GDP. 2017 predictions moved from 1.4% to 2%, coming from both an improvement in household consumption and business investment. At the same time it also moved down its unemployment rate forecast for 2017 from 5.4% to 5%. But it kept its inflation forecast broadly unchanged.
The Bank has managed this by changing its view on how much slack there is still left in the labour market. It does not think wages are picking up fast enough for the level of unemployment that we are at. So it has lowered where it thinks the equilibrium rate of unemployment is – moving this down from 5% to 4.5%.
This gives the Bank of England plenty of room this year to keep interest rates the same even if inflation goes above the target. What will most likely call this into question is if wage growth were to surprise to the upside.
A very interesting throw-away comment from Mr Carney in the press conference: “we are coming to the last seconds of Central Bankers 15 minutes of fame”.
Eurozone CPI has picked up quite dramatically in recent months from 0.5% in October 2016 and just 3 months later to a very respectable 1.8%. Ok, most of this is base effects of energy and food inflation coming through, but the average CPI rate in the Eurozone has only been 1.7% since 2001. At the ECB meeting in December, Draghi managed to extend the current monetary easing QE policy until the end of 2017 when we coming off the back of very low prints. In other words, he had the cover of very low inflation prints to toughen the stance that more monetary stimulus was warranted.
While the 1.8% rate we saw for January is not exactly anything to worry about and the programme will most likely continue in its pre-announced version, Draghi will no doubt play down the inflation prints, stating this is base effects rather than self-sustaining over the medium term. However the disconcerting voices over the QE policy will become louder and I can easily imagine a scenario in the summer months where the “taper” word is being openly discussed.