We are back to discussing the market’s favourite topic these days: inflation. The debate is ubiquitous, as everyone is trying to figure out whether this is a fluke or a true regime change, which, if not acknowledged soon – specifically by central banks – will bring doom upon us all. Ever since the discussion started, we have opted for the former explanation, and as time goes on, we become more and more confident about our outlook.
Nonetheless, for the sake of argument, let us imagine that inflation really is back for good and that, as some market commentators claim, the US Federal Reserve (Fed) is ‘behind the curve’. In that case, the suggested remedy seems to be to taper asset purchases sooner rather than later. Without any disrespect to said individuals, in our view this completely misses the point. The fact of the matter is that what the central bank does or does not do with its asset purchase programme matters little for inflation nowadays. Let us explain.
Background: monetarism & the credit channel
In the 1960s, Milton Friedman popularised one of the most influential monetary theories to the present day, monetarism. The theory’s main conclusion is that inflation is determined by the central bank’s money supply: as money supply increases, interest rates go down, stimulating private credit and boosting demand. This, in turn, applies upward pressure on prices. In such a context, it makes sense for some to sound the alarm, for money supply growth is at a record high of 25% on a yearly basis. High, but much lower, money-supply growth rates have preceded past runaway inflation episodes, such as in the late 1970s/early 1980s.
But this logical chain ignores a crucial aspect, which may have seemed to be set in stone and obvious in the previous century but is no longer – the credit channel. The credit transmission mechanism has been largely decommissioned over the past decade and is not showing any signs of revival, with bank loan ratios and monetary velocity at historical lows. The private sector’s appetite for credit in developed countries maxed out following the Global Financial Crisis. Ever since then, the private sector has been in a structural savings surplus, ushering us into the era of secular stagnation.
What happens to all that central bank liquidity if it does not get lent to private households and companies?
It flows into the path of least resistance, that is, financial assets, thereby inflating asset prices across the board. This is exactly what we have been observing over the last ten years: while central bankers scratched their heads at the continuous undershooting of their inflation target, the S&P 500 price index rose by 190% (January 2010 to December 2019). This created a positive wealth effect that benefited only the highest deciles of the income and wealth distributions, who proceeded to reinvest and save the extra windfalls while spending only an irrelevant fraction. The lower deciles of the income distribution have seen little to none of those gains, but it is exactly these households that have a high propensity to consume. Given the right means, using tools like negative taxation and continuous fiscal stimulus programmes, these households could pull us out of secular stagnation. We do not believe we are at this point yet.
Where will the journey end?
Going back to the question of tapering, when liquidity is pulled out of the system, it triggers a negative wealth effect. At the margin, it could slow economic activity and inflation, though not materially. Initially, however, it could, paradoxically, potentially increase inflationary pressures by increasing the cost of corporate capital, thereby constraining the supply of goods and commodities. This, of course, turns the whole concept that people have of tapering onto its head.
This is an extract from the latest CIO Weekly.
What lies ahead in the economy and financial markets? Our Group Chief Investment Officer explains.