I’ve long clung to the paradigm of low rates for longer. An associated tenet of this paradigm is that inflation was under control, nobbled by
- Excess global savings and chronic capital imbalances
- Rapid technological change
As long as these structural factors were in play, I could see no sensible path back to high or even higher inflation rates. Crucially the macro economics numbers showed no evidence that inflation was the problem – in fact quite the opposite as central bankers fought valiantly against deflation in Japan and the Euro zone.
Now that Covid 19 has come along and we’ve seen the first visible sings of QE Unbound as well as direct monetary financing of massive deficits, I’m not so sure that I would stick to the Low for longer argument. It seems obvious to me that although globalisation is not about to head into full retreat, it will now be under huge pressure and will probably be forced in to a standstill of some sort or even gentle decline.
That said those chronic capital imbalances haven’t gone away but we’re mid way through an epic experiment in capital destruction which might drain some of that reservoir of liquidity. As for the third tailwind, technological change, I see no fundamental change.
Nevertheless, it is important to separate out what might happen in the short term – the next 12 months – from the medium to longer term i.e the next 3 to 5 years.
I see no absolutely indication that inflation will roar back in the short term, in fact quite the opposite.
But over the medium term, it seems to me that we are finally seeing an alignment of factors that could, might, possibly produce much higher inflation.
The first key indicator is that use of the money printing presses by the UK government. Jefferies Chief economist David Owen, has a good summary
“We still assume that the vast majority of financing will be through debt issuance, with much ending up on the BoE balance sheet, possibly as part of an ever-expanding QE programme. The chart below may help put this into long-term context showing central government borrowing alongside BoE holdings of government debt securities since 1697. As we continue to highlight, even without direct monetary financing of the UK budget deficit, the UK broad money supply M4 (currently standing at just over £2.5 trillion) could be growing by 10% or more by the end of this year.”
Now, one doesn’t have to be a monetarist to wonder whether this substantial increase in money supply might have some impact on inflation.
London based research firm Cross Border Capital map out the next steps in what might happen.
“The huge monetization of deficits planned by Central Banks, culminating in a one-third jump in the size of their balance sheets, could lead to 15-20% monetary growth in 2020. With velocity already depressed and real GDP growth slow, this surely must lead to faster inflation of circa 5-10% in the US from 2021. Bonds beware. Gold looks great…..A cyclical shift from ‘low-low’ inflation to ‘higher-low’ inflation favours equities over bonds, with some improvement in the outlook for real assets. Equities prefer low inflation regimes, but they still outperform fixed income when inflation is rising largely because earnings can keep pace with rising prices”.
The last step in the analysis comes from a guest blog on the Bond Vigilante’s website by Randeep Somel, an equity fund manager at M&G. You can read it here….
It’s entitled “Has globalisation peaked? If so, what are the implications?” and it puts together the final structural explanation for pushing inflation rates higher. The decline of gloablisation.
“Should the slow but increasingly important trend of trade barriers begin to rise, and there be excess stimulus in the world economy once we have returned to some level of normality, we are likely to see some longer term economic implications.
The death of the more than 30-year bull market in US Treasuries has been predicted many times. It will require sustained inflation in the system to force longer term interest rates up. While our minds could not be further away from that thought today, the ingredients for this eventuality are all just going in to the mix.”