Could inflation finally, actually, truly, for real this time, be about to rear its head?
Warnings of soaring consumer prices have accompanied every round of central bank easing, since countries around the world began using unconventional monetary policy to tackle the Great Recession. Largely, such fears have proven misplaced.
The question this weekend is whether that may be about to change, because of the breakthrough decision of the US Federal Reserve to add an employment target for monetary policy and to signal it would allow inflation to rise above its previously ironclad 2 per cent target until unemployment dips below 6.5 per cent.
“Is the higher tolerance for inflation over 2 per cent important?” asks Eric Green, global head of foreign exchange, rates and commodities at TD Securities. “Only in so far as [Federal Reserve chairman] Ben Bernanke has admitted what we all know to be the case. The Fed wants and need higher inflation, the world is still disinflationary and higher inflation coupled with lower real rates is a nice salve for the debt burden.”
An increased tolerance for inflation seems to be spreading in central bank thinking.
In the UK, George Osborne, finance minister, has signalled he would consider scrapping Britain’s 2 per cent inflation target in favour of a more growth-focused objective. Earlier in the week, Mark Carney, the Canadian central bank governor, who will take over as head of the Bank of England next year, had suggested a move toward nominal GDP targeting could be justified in exceptional circumstances.
Mr Carney was “leading international debate and opinion” on new central bank targets, according to Mr Osborne.
So far, market reaction has been limited.
“I wouldn’t say inflation expectations have been materially damaged by what we have seen this week,” says Andrew Milligan, head of global strategy at Standard Life Investments in Edinburgh. “But it is absolutely clear that inflation prospects are something a lot of our clients are asking us about. Anyone with a longer time horizon is questioning: ‘where could this lead? Are we going to see a step up in inflation expectations?’.”
In the US, market reaction to the Fed’s new policy this week has been muted. Five-year breakevens on inflation-protected Treasuries, a measure of inflation expectations, did rise after the Fed’s announcement, from 2.07 per cent to 2.10 per cent, but they ebbed again on Thursday and remain far below the 2.37 per cent level to which they spiked in September, when the Fed announced its previous round of bond buying.
In the years before the credit crisis, long before Mr Bernanke hosed money into the financial system, the average breakeven was 2.5 per cent.
There was a weaker than usual amount of demand for 30-year Treasuries at an auction late this week, potentially signifying investor caution about future inflation, but gold, a favourite hedge for inflation hawks, couldn’t muster a rally.
Jim Paulsen, chief investment strategist at Wells Capital Management, is among those who fear the market is too sanguine.
“Many believe the continued deceleration of wage inflation in this recovery is a unique event tied to the severity of the 2008 recession and to the still elevated 7.7 per cent unemployment rate.
“However, the behaviour of wages in the contemporary recovery is certainly not unique. Rather, wage inflation is following its pattern of the last three recoveries quite closely. If wages continue to respond as they have in the last 30 years, labour inflation will likely begin to rise again sometime in 2013.”
Barclays has upped its inflation forecast for the end of next year to 2.7 per cent, on the Fed’s preferred measure, excluding volatile food and energy prices. One reason is that housing costs, rents in particular, could jump as the economy strengthens and more 20-somethings are able to fly the parental nest.
Yet the market impact is likely to be small, says Larry Kantor, Barclays head of research. A bond market sell-off, which would be expected if inflation rises, may only come when the Fed signals tighter policy, he says, and given the greater flexibility around its inflation target, that may not need to be early.
As John Briggs, strategist at RBS Securities, points out, the inflation target is based on the Fed’s internal projections for consumer prices “between one and two years out” - a projection, Mr Briggs says, that could be slow to adjust to an unexpected rise in short-term inflation.
The US and UK discussion about the possible desirability of a dose of higher-than-usual inflation sets these countries further apart from continental European central bankers.
The European Central Bank has been forced over the past year into exceptional steps to prevent the eurozone falling apart. It has also downgraded its 2013 forecasts and worries about high unemployment, especially in southern Europe. But it would be hugely controversial, especially in Germany, if Mario Draghi, president, ever hinted the ECB might compromise its primary objective of controlling inflation.
Jim Reid, senior strategist at Deutsche Bank, writes in a note: “Although the ECB has changed significantly, we’re a long, long way off a world where the ECB would say that they would buy Spanish government bonds for as long as Spanish unemployment remained above a certain level.”
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