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State of the Debate - Last Chance

Richard Hoey
Chief Economist, Dreyfus

Richard Hoey

This is Richard Hoey of Dreyfus with an update on March 25, 2015. 

A key question today is whether the major central banks, in the aftermath of a prolonged deceleration of inflation, will succeed over the next several years in their anti-deflationary policies.  Many central banks in developed countries are attempting to raise inflation up to their inflation targets, which are generally at or close to 2%.  This is the mirror image opposite of the situation three and a half decades ago after a prolonged uptrend in inflation.  The key question in 1981 was whether Paul Volcker and other central bankers would eventually succeed in their anti-inflationary policy.  Our view then was and now is that monetary policy is extremely powerful, likely to eventually drive inflation in the desired direction if it is aggressive enough.  Since monetary policy works with long and variable lags, the timing of the response is uncertain.  Restrictive policy under Paul Volcker was certainly aggressive enough, with peak interest rates in 1981 of 21.5% for the prime rate, 17% for the 90-day Treasury bill rate, 16% for 10-year Treasuries and 15.20% for 30-year Treasuries.  This triggered a long decline in inflation and interest rates, lasting more than three decades. 

We outlined the logic for a persistent decline in long-term yields in our May 25, 1981 Forbes column, entitled “Last Chance This Century.”  The actual long-term secular decline in bond yields lasted over three decades.  We expect 2015 to mark the mirror image opposite of 1981, with an extreme low in developed country sovereign bond yields likely to mark the end of the long secular decline in bond yields, to be followed by a gradual multiyear upward drift in bond yields.  It may prove to be a “reverse last chance this century” from a recent low yield slightly above 2% for 30-year Treasury bonds, roughly 1300 basis points below the 1981 peak yield.  The most extreme low yields in Europe may occur later this year, as the ECB drives European sovereign yields further below free market levels. 

Today, gross monetary policy (excluding the impact of regulatory tightening) is aggressively stimulative in many developed countries, with massive increases in central bank balance sheets, low and even negative policy rates and intentional manipulation down of long-term government bond yields below free market levels.  The central banks have placed such a high priority on fighting deflation risks, that they are accepting the risk of asset bubbles in order to generate an upward shift in current spending.  Given the intensity of anti-deflationary policies which have been adopted by the central banks, higher inflation should return--just not soon.  We are quite skeptical about the concept that most central banks will prove unable to accelerate inflation in the long run.  Even the Eurozone, whose rigid policy rules reinforce deflationary risk, should eventually experience a modest uptrend in core inflation.  This should be largely due to economic growth running faster than a low potential growth rate, combined with substantial currency weakness.  We expect a gradual normalization of inflation rather than an upsurge to excessive inflation. 

Why is inflation so low today, despite low interest rates and quantitative easing?  One reason is the long shadow of the Great Recession, which created a legacy of excess capacity in many countries, which is gradually being worked off.  Another reason is the long shadow of the Global Financial Crisis, which necessitated a long recuperation of the financial system and motivated aggressively restrictive regulatory policy, a regulatory brake which has slowed the response to easy monetary policy.  Global labor arbitrage, currency mercantilism and subsidies for maintaining and expanding productive capacity have increased the market share of emerging countries to a very substantial share of the overall global economy, resulting in weak tradable goods prices and wages in the developed countries.  Finally, technological innovation has had a disinflationary impact, notably in the U.S. oil and gas sector. 

The initial impact of stimulative central bank policies has been very powerful in the asset markets but has been more gradual in generating strength in real economic growth and inflation, the two components of nominal GDP growth.  The transmission of central bank easing to the real economy has been relatively inefficient due to: (1) deleveraging of debt by private sector borrowers, with the degree of progress varying country by country, (2) the inability or reluctance to use fiscal stimulus, (3) voluntary deleveraging by financial intermediaries to rebuild damaged balance sheets, and (4) forced deleveraging by financial intermediaries due to repeated rounds of regulatory tightening.  Net monetary policy (gross monetary policy minus regulatory tightening) is aggressively stimulative for asset prices, but only mildly stimulative for economic growth.  However, the central banks appear fully willing to overcome this transmission problem with an extremely aggressive stance of gross monetary policy. 

Some forms of credit expansion provide substantial support for current spending and economic activity and others do not.  The current mix of a central bank accelerator and a regulatory brake has driven a boom in existing asset prices combined with more limited improvement in credit availability for current spending.  The central banks and financial regulators did not set out to create a “boon for billionaires monetary policy,” while suppressing the interest income of consumers and providing only limited support for the growth of credit for current spending, but that is what has occurred, in our opinion.  On balance, we believe that net monetary policy is somewhat stimulative, as excess liquidity is not just flooding into the asset markets, but is also gradually trickling into the real economy.  We believe that there is a trend of gradual improvement in the transmission of monetary ease into current spending.  We believe that the “legacy drags” from the Great Recession and the Global Financial Crisis are diminishing year by year, which should foster greater “traction” for monetary policy. 

Cyclical forces are likely to drive inflation in the U.S., UK, Europe and Japan gradually higher over the next several years.  We expect an “inflation normalization convoy,” with the U.S. and UK normalizing core inflation to their targets over the next 18 months to two years and Japan and Europe normalizing core inflation to their targets over the next four years.  The labor market in the U.S. is tightening month after month.  As a result, we expect wage inflation to drift gradually higher over the next several years.  Service inflation should begin to reflect tighter labor markets.  Given the depressed labor share of national income, we expect the Fed to be tentative rather than aggressive in tightening to resist rising wage inflation.  The first stages of increased wage inflation are likely to be regarded as a desirable normalization of labor income rather than an inflationary threat to be aggressively resisted.  Over the course of time, the impact of energy prices should shift from deflationary to inflationary.  It is the rate of change and not the level of oil prices which influences overall inflation rates.  By 2016, the 12-month rate of change of oil prices should shift from down to up, contributing to an upward drift in reported inflation.  Overall, we believe that the U.S. and other major countries are at the cyclical lows in inflation, which should drift gradually higher over the course of the next several years in the context of the long expansion we expect. 

While we are optimistic about the cyclical outlook for a long expansion in the world economy, we believe this will occur in a longer-term context of a lower path for potential GDP, reflecting both a one-time downshift due to the effect of the Great Recession plus a slowing potential GDP growth rate in the future due to: (1) deteriorating demographics and (2) suboptimal economic policy.  The growth rate of the working-age population is decelerating in many parts of the world, with absolute declines in some countries.  That is not a significant cyclical problem due to high current unemployment rates in many countries.  However, it should contribute to a downshift in trend economic growth in the long run.  Improved incentives for work could somewhat mitigate the effect of these demographic trends on future labor supply growth, but that has not yet occurred.  We believe that there is also a drag on potential GDP growth from suboptimal economic policies.  For each country, suboptimal economic policy is a choice, not a destiny.  A key swing factor in the economic outlook for each country is the medium-term trend of improvement or deterioration in the credibility of economic policy. 

Given the slow pace of global growth, there has been concern about deflation, disinflation and lowflation.  Deflation is a pattern of declining prices, disinflation is a downward shift in the pace of positive inflation and lowflation is positive inflation persisting at a pace only slightly above zero.  One concern is that deflation can make excessive debt more burdensome.  Another concern is that when nominal interest rates are near zero, deflation or lowflation can make it hard for central banks to generate sufficiently low or negative real interest rates (nominal rates minus actual or expected inflation) in order to stimulate borrowing.  Concern about losing monetary “traction” is one reason central banks are so aggressively battling risks of disinflation, lowflation or deflation. 

It is crucial to recognize it is the relative growth of demand versus supply which will determine future inflation trends.  Slower-than-historical growth rates in demand do not ensure disinflation or deflation if supply growth decelerates even more.  Cyclically, if demand growth outpaces supply growth, disinflationary forces should ebb and inflation should drift gradually higher, even if both demand growth and supply growth are slower than in the past.  Current central bank policy is designed to generate demand growth in excess of supply growth, a goal we expect them to achieve, due in part to slower growth in potential GDP. 

Despite the likely onset later this year of baby steps towards normalization of the Federal funds rate, we expect U.S. monetary policy to remain easy.  The core of the Federal Reserve appears to have a dovish perspective on a variety of issues: (1) the state of the labor market, (2) the risk of future inflation, (3) potential tolerance of a period of core inflation above 2%, (4) the risk of asset bubbles and the Fed’s role in preventing them, and (5) the prospect of a path for the Federal funds rate below historic norms.  The result should be a prolonged eight-year economic expansion (2009 to 2017), with a gradual rise in the Fed funds rate in late 2015 and 2016 followed by a more aggressive monetary tightening in 2017 or 2018 after the 2016 Presidential election.  In the meantime, we believe that monetary policy will support a prolonged economic expansion. 

Long-term interest rates have been held down by restricted net supply of sovereign bonds.  Safe sovereign bonds are scarce due to limited net supply from the big four countries (the U.S., UK, Japan and Germany) exacerbated by central bank purchases, which have removed bond supply from the markets and manipulated down sovereign bond yields in all of these countries.  There is likely to be a prolonged normalization of bond yields over the coming years as core sovereign bond markets gradually return to free market pricing.  But we expect this to be a very gradual process.  A decade or a decade-and-a-half from today, the interest costs of sovereign debt likely will have risen substantially, in our opinion, but that should not be a significant problem for the next half-decade. 

Quantitative easing by the G4 central banks has probably been the largest market manipulation in world history, in our opinion.  As the yield and price of sovereign bonds are the benchmarks of asset valuation, there is now a “crooked ruler” effect.  It is very difficult to distinguish between free market fair value and the effects of the “central bank bubble machine.”  Central banks have succeeded in driving asset prices higher.  So far, we are hopeful that the long economic expansion we expect will validate current valuations, but the risks of a transition from a bull market to a bubble/bust pattern are palpable. 

For much of the last three decades, bond holders often earned “coupon plus” total returns, as the long downtrend in yields was reflected in an uptrend in many bond prices.  In those periods, current yield plus capital gains generated favorable total returns.  While nobody knows what the future will bring, we believe that the risk is growing of a long period of “coupon minus” bond returns, as a prolonged upward drift in yields would be reflected in a downward drift in many bond prices.  Rather than a fast spike in interest rates which would generate a quick return to attractive yield levels, we expect a gradual and prolonged upward drift in yields over the coming years.

The statements expressed in this commentary are those of the author as of the date of the article and do not necessarily represent the views its affiliates. The views expressed are subject to change rapidly as economic and market conditions dictate of Dreyfus or, and the statements in the commentary should not be construed as an offer to sell or a solicitation to buy any security. The commentary is provided as a general market overview and should not be considered investment advice or predictive of future market performance. Contact Dreyfus or your advisor for more current information.