New Paradigm, Old Approach

Global Fixed Income Update

August 16, 2019

Thirty years ago, New Zealand became the first country to formally implement an inflation targeting regimen. In the following years, many other countries adopted the same framework. The experiment was largely successful, particularly in the case of select emerging markets that could also count on a fiscal anchor, or improved fiscal discipline, to reduce the risk of deficit monetization. Most inflation-targeting central banks could credibly signal they would increase real interest rates in order to bring inflation down to the targets. They also had ample room to cut nominal interest rates, should their projections signal an unwanted decline in inflation below the targets. Exchange rates floated (largely) freely and their repricing helped central banks achieve their inflation objectives.

Fast forward 30 years and earlier this month the Reserve Bank of New Zealand (RBNZ) was again at the forefront of inflation targeting, this time delivering a largerthan- expected rate cut, a move that sent global yields sharply down (helped by the Central Banks of India and Thailand, which also cut rates that day). The RBNZ decision to cut by a larger-than-expected 50 basis points (bps) took place despite inflation being only modestly below target and the unemployment rate being very close to a historical low and still declining level. The bank’s forecasts indeed pointed to lower inflation ahead. However, the size and the timing of the rate cut suggests a shift in approach, or a refocused goal of fighting low inflation with the same impetus that was once directed towards combating high inflation. Central bankers around the world, from the U.S. Federal Reserve to the European Central Bank (ECB), have started talking about the importance of a symmetric inflation objective, letting inflation overshoot the target instead of managing policy as if the target was a ceiling.

So far the market is unimpressed, probably correctly so. Global treasury yields continue heading lower, and the balance of risks is tilted to a further decline in interest rates. Not only are nominal yields going lower, but inflation breakevens are heading south as well. In other words, curves are pricing lower real yields and lower inflation.

Markets Pricing Very Low Rates, For Longer

3-months rate, 5 years from now (%)

Source: Bloomberg

Can monetary policy by itself engineer higher inflation?

The discussion on the benefits of letting inflation run hot would probably not be taking place if policymakers around the globe were not concerned about lack of inflation. Much has changed since the adoption of inflation targeting with most developed economies now dealing with deflationary pressures and inflation expectations anchored at low levels. The phenomenon is widespread, with inflation undershooting targets in several emerging market economies as well. As a result, central banks are ready to pursue a policy path intended to drive inflation and inflation expectations higher and allowing them to overshoot long term targets. It is very likely that in September the ECB will announce another cut of the deposit rate, bringing it deeper into negative rate territory. ECB balance sheet expansion will likely resume later this year. Rate cuts could also be under consideration by the Bank of Japan.

Renewed focus on expanding monetary policy stimulus is happening at the same time the forces that have driven inflation lower are still present and will likely persist. China once drove global prices down by selling cheap manufactured goods to the world. Now it continues to do so while its corporate sector digests high leverage and focuses on sales and market share rather than profit margins. Other emerging Asian economies have picked up any slack left by China in the cheap consumer goods global supply chain. Workers will continue to have low wage bargaining power, if the only visible source of productivity gain is from further mechanization.

Japan has been mentioned as an example of the rather underwhelming track record of conventional (rate cuts) and unconventional (asset purchases) monetary policies in creating inflation in developed economies. More worrisome is the fact that several economies share some of the factors that rendered higher inflation in Japan an elusive goal. The list is rather long: aging (and perhaps even shrinking) populations, sticky inflation expectations, social and economic obstacles to labor mobility and worker bargaining power, high corporate sector leverage, and limited space for fiscal stimulus due to already elevated public sector debt to GDP. It is not even clear if the public would welcome faster nominal price increases, since it’s uncertain what would happen to wages purchasing power. As in Japan, economies with large elderly populations could experience low popular support for higher inflation policies since inflation could erode the real value of savings and be perceived as a transfer from old to young generations, who can still be compensated with higher nominal wages.

Curve Inversion

A cynical view is that the discussion about a new paradigm for monetary policy and the actual implementation of easier policies – including negative interest rates and further quantitative easing – is nothing more than an attempt to weaken the currency, boost export competitiveness and export deflation to trade partners.

Empirically, weaker exchange rates have been linked to higher inflation (through higher import prices, among other channels) and inflation expectations. The problem arises when the drivers of low inflation and low growth are shared across economies – high leverage, low workers’ bargaining power due to mechanization and globalization, etc. In others words, when inflation is largely being driven by global factors, rather than country-specific ones, then policies become more synchronized across different economies. Hence it is hard to weaken your economy’s currency through monetary policy when everybody else is easing as well.

Putting all these obstacles together – the structural global factors weighing on inflation, and the “crowded field” of Central banks in easing mode – it is not surprising that markets exhibit doubt that monetary policy by itself will lead to sustained growth and inflation.

Market skepticism regarding the success of monetary “reflation” policies is captured in yield curve inversion. Following the recent escalation of trade tensions with China, the U.S. Treasuries curve slope between 2 years and 10 years Treasury yields flattened and is about to invert. The United Kingdom Gilts 2s10s curve is inverted. Curve flattening usually occurs after a period of monetary policy tightening. It is very telling, therefore, that even in the Eurozone, where policy normalization never took place, we are observing very fast flattening of the German Bunds curve.

Not a Lot of Faith in Reflation

2-year vs 10-year Treasury Yield Slope Inversion

Source: Bloomberg

The rather obvious conclusion is that monetary policy cannot do it all without the support of other areas of policymaking, ranging from growth enhancing reforms, to fiscal policy and constructive negotiations on international trade issues. Inflation targeting did not become a successful endeavor in those countries where the other pillars of economic policy (most importantly, fiscal discipline) were inconsistent with the goal of pursuing lower and more stable inflation. Likewise, this new framework for monetary policy will most likely be unsuccessful if more of the same, i.e. further monetary policy easing, is the only game in town.

 

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