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Last week’s 25 basis point hike by the Fed was so widely expected that some market participants were looking for 50 basis points. Combined with some fairly dovish comments from Janet Yellen, the result was a sharp fall in yields across the curve and a sell-off of the dollar. Of particular note was Yellen’s comment that she sees the equilibrium rate for Fed funds as being, obviously, higher than the current target of 0.75 to 1.00% but not significantly so: somewhere around 3%, if the current ‘dot plot’ pans out.
This all sounds very reassuring until one considers that inflation is already running at 1.7% according to the PCE measure preferred by the Fed, meaning that the Fed is happy to be running with real short-term rates at almost minus 1% and, by its own admission, is in no great hurry to return to positive real rates.
Here in the UK, the Bank of England appears similarly reluctant to embark on a process of rate normalisation. This is doubtless on account of MPC members’ embarrassment at having cut rates last August in a move that seems either overly cautious or panicked, depending on how much benefit of the doubt one is prepared to give. Perhaps the committee members still have George Osborne’s apocalyptic forecasts ahead of the referendum ringing in their ears. In fairness, nothing has actually happened yet when it comes to Brexit – something that the most cavalier Brexiteers seem to forget. We are not yet in a post-Brexit world, merely a post-referendum one and there could be shocks ahead.
Again, though, we are observing a central bank that is perfectly happy to preside over negative real rates. UK CPI was 1.8% in January, meaning that real rates are minus 1.55%. It is tempting to ponder whether, given the remarkably robust performance of the UK economy over the last nine months, such monetary largesse is strictly necessary.
In truth, on both sides of the Atlantic, central banks are hoping for a period of sustained inflation. Ideally, this will be ‘Goldilocks’ inflation – just high enough to make some meaningful inroads into the monstrous piles of government debt that are still being accumulated, but not so high as to get out of control and require sharp rate rises to tame it.
Janet Yellen was at her Delphic best last week when explaining what was meant by the Fed’s symmetric view of inflation – or more specifically its symmetric tolerance of undershoots and overshoots. Her comments have been interpreted by many as meaning that the Fed will fight an overshoot of the inflation target as aggressively as it fought the undershoot but this is highly unlikely. Given that US inflation has remained below the 2% target for the vast majority of the time since the financial crisis, it simply makes no sense not to allow inflation to overshoot the target, otherwise the economy will continue to be burdened by overly high levels of government debt.
If this is true of the US, it is just as true of the UK and even more so of the Eurozone. Italy’s debt/GDP ratio of around 130% has reached a level from which it is very unlikely to fall without a dose of inflation. Certainly, austerity is not working and there has been no Italian real growth since 2000. This is why Mario Draghi was so delighted to declare victory over deflation ten days ago, saying that policymakers ‘do not anticipate that it will be necessary to lower rates further’. That is good news but begs the question as to when the ECB will begin the process of rate normalisation. It appears this will be another central bank in no particular hurry and happy to preside over negative real rates for a long time yet.
Then there is the thorny question of reversing QE. Since QE was, in the first place, an untried experiment, it follows that eventually unwinding it will be another shot in the dark. At the moment, central banks are rolling over maturing bonds to maintain the level of QE assets on their balance sheet – around $4.5 trillion and £435 billion in the case of the Fed and Bank of England respectively. The ECB, meanwhile, is still actively buying assets.
It has been argued by ex-Fed Chairman, Ben Bernanke, that the Fed should only start to reverse QE, which would lead to a reduction in the money supply, as and when interest rates are substantially back to normal. This is so that there will some room for manoeuvre to cut rates, should the process have unanticipated adverse consequences. This is no doubt sensible but also very convenient. It beggars belief that the US or UK Treasuries will ever be in a position to offload much of their balance sheets onto the markets by selling their QE bonds – the risk of sharply higher medium-term rates would be too great. The prospect of governments repaying the central banks on the maturity of the bonds looks even less likely. The UK’s £435 billion of total QE, for example, is almost exactly equivalent to the annual government revenues from income tax, national insurance and VAT combined.
The only solution known to work in these circumstances is the tried and tested technique of inflating away the real value of the debt. Then, at some point many years away, the central banks’ balance sheets will eventually be reduced as QE is reversed for what will by then be the price of a decent terraced house in Fulham. There are fewer surprises when one judges politicians and central bankers not by what they say but by what they do. Their ongoing preference for negative real interest rates portends a tolerance of future, above-target inflation.
We shall get more of a flavour of rising UK inflation tomorrow with the release of February’s data. CPI is expected to have risen from 1.8% to 2.1% (pushing the real Bank Rate down to negative 1.85%). RPI is expected to have risen from 2.6% to 2.9%. If the CPI projection is correct, the index will be above target for the first time since November 2013 and dangerously close to average earnings growth of just 2.2%, threatening stagnation in real wage growth. Expect much emphasis in due course from the MPC on core CPI which is expected to have risen only a notch from 1.6% to 1.7%.
Thursday promises more insight into the consumer’s psyche with retail sales expected to have risen at an annualised rate of 2.6% in February. Given the squeeze on real incomes, this is a figure with the potential to disappoint and put the brakes on sterling’s recent rise to 1.2410 and 1.1540 against the dollar and euro respectively. The week rounds off with PMI date from the Eurozone where the March manufacturing and services indices are both anticipated to be 55.3, to show ongoing recovery.
All views expressed here are the author’s own and are based on information and data available at the time of writing.
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