After almost a decade of QE and loose monetary policy, inflation is nowhere to be seen in the developed world.
Warning of upside risk in consumer prices has become something akin to crying wolf. But Donald Trump’s proposed fiscal measures could prove the missing piece of the global inflationary puzzle.
As a result, inflation is a risk that must be taken seriously. Central banks are already under political pressure to raise interest rates, and if given an excuse to do so by rising inflation, they may respond sharply over the next two years, bringing an unexpectedly abrupt end to the QE era. The potential for markets to be caught off-guard by such a move is staggering.
The fact that Trump’s proposed policies amount to a fiscal expansion is blindingly obvious, but the case bears repeating.
His tax plan is estimated by the Tax Policy Centre as potentially decreasing revenues by $6.2 trillion over the next decade. More charitable “dynamic” analysis of the plan’s effects, which assume an increase in the size of the economy, still shows a substantial fall in revenue. When increases to infrastructure spending and a boost in the military budget are factored in, it is clear that Trump’s plans will almost certainly represent a substantial fiscal expansion.
Such an open-handed approach to government spending may seem unusual at first. After all, it was the Republican Party itself that aggressively opposed any increase in the national debt under Obama. But Trump’s policy is part of a wider global trend where politicians are finally heeding economists’ calls for looser fiscal policy.
Japan’s Shinzo Abe has been calling for co-ordinated fiscal action from developed world leaders to support inflation globally. Philip Hammond is backing away from his predecessor’s goals for a balanced budget in the immediate future. Only in the Eurozone do German politicians, to the great misfortune of the continent, still aggressively defend the old balanced budget dogma. So the move towards looser fiscal policy in the US is less a rogue wave than perhaps the first sign of the tide changing.
A rising fiscal tide is likely to lift the inflationary boat across the developed world. This is a conventional idea in macroeconomics and, indeed, central bankers have been imploring as much of policy-makers for some time, as far as their mandates allow.
But the policy change comes at an interesting time for developed world economies, many of which already have tight labour markets. The risk is that rising cost pressure will drive up inflation faster than expected once fiscal policy boosts demand.
Upside inflation risk is an old warning. Indeed, early warnings of inflation in the wake of the first QE programmes have so frequently been proven wrong that it has become something of an old wives’ tale. Paul Krugman has called those making such warnings “inflationistas”. The label is not unjustified considering just how wrong those predictions have been for years.
But fiscal policy may prove to be the missing piece of the puzzle. After all, in a classical Keynesian framework, loose monetary policy only goes so far when rates are at the lower bound. Government spending, of the sort that now seems around the corner, is needed to revive the spirits of inflation.
Markets have taken note. Fixed income yields are up across the board, most spectacularly in US 10-year treasuries, which have seen yields rocket above 2 per cent for the first time since January. Federal Funds futures markets, which initially reflected expectations of a more hesitant Fed in the wake of the election, are now once again reflecting near certainty that rate hikes are coming in the immediate future.
But despite recent moves, market pricing is still light years away from reflecting a true hiking cycle from the Fed. It may be forced to abandon its assurances of a slow, steady, and modest path of rate increases, especially in the face of a tight labour market. This would mean interest rates, and fixed income yields, rising at a pace that has been unimaginable for the better part of this decade.
Political pressure is also worth considering. Loose monetary policy has become an easy political punching bag on both sides of the Atlantic, with Trump stating that the Fed has created a “false economy”. In Britain, the Bank of England has been accused of losing the plot, and the European Central Bank’s interest rate policy is a frequent target for German politicians.
In the face of rising inflation and political pressure, how confident can we be that central banks will hold their nerve and avoid slamming the monetary breaks?
If rising inflation does indeed result in a strong monetary response, the changes that will result in markets will be seismic. In effect, the QE era could be unwound significantly earlier than expected by the combination of rising inflation and political pressure to end loose monetary policy. A US yield curve in the process of normalisation would place immense pressure on emerging market currencies.
The S&P 500, which has risen and then plateaued in unison with the Fed’s balance sheet during a time of dubious earnings, could face a moment of reckoning alongside all other markets that have relied on a low-rate paradigm. Fixed income investors may finally awake from the stupor induced by years of easy money, resulting in the taper tantrum to end all taper tantrums. Combined with a potential change in the attitude of the US to the very concept of free trade, the consequences for emerging markets could be cataclysmic.
Inflation remains nowhere in sight, and of course Trump could find his big-spending impulses blocked by an unexpectedly disciplined legislature. But the alternative scenario, a return of inflation and a rapid end of the QE era, could quickly become the main theme for global markets in 2017.