27/04/2023 Everyone has a plan until they get punched in the mouth –
Mike Tyson. For central bankers that punch is double-digit inflation. So, what’s the plan
now? Two things to consider – one is headline inflation, which is coming down due to the
energy base effect. Two, core inflation really isn’t budging. Look at the Fed. It has hiked
rates by 500bps (give or take given this is being written ahead of the May meeting) in a
year. Yet core inflation remains well above 5%. Why is that? Partly, it’s because rate hikes
take time to have an impact. But even with rate hikes we saw last year financial conditions
loosening. They are not having the same effect as they might have done in the past – for all
sorts of reasons to do with the way financial markets have changed and the transmission of
monetary policy is probably weaker than it once was – non-bank lending, etc. Also
diminishing marginal returns from each hike. More importantly perhaps, we’ve seen an
upending of the globalisation trend of the last 40 years which pushed prices down. Global
value chains are evolving fast and not in a way that will keep prices down. The European
Central Bank president, Christine Lagarde, talked about this recently in a rather remarkable
speech. I read the words as a clear signal that we are about to go into a protracted
economic (and maybe real) war, and it will require the mobilisation of the state and people
– developed world central banks (Fed, ECB, BoE, BoC, RBA) will act together to orchestrate
fiscal spending and suppress yields. So, you can forget 2% inflation. She said the world is
seeing “more instability as global supply elasticity wanes” and may see “more multipolarity
as geopolitical tensions continue to mount”. A period of “relative stability may now be
giving way to one of lasting instability resulting in lower growth, higher costs and more
uncertain trade partnerships. Instead of more elastic global supply, we could face the risk
of repeated supply shocks”. If that is the case, inflation is not going to rest around 2%
easily, whatever central banks try. So, what’s wrong with 4% inflation?
We’ve talked about this before. Former Bank of Japan Governor Shirakawa had written an
article for the IMF on inflation targeting, urging “now that we know its limitations, the
time is ripe to reconsider the intellectual foundation on which we have relied for the past
30 years and renew our framework for monetary policy”. Shirakawa said he is ‘sceptical’ of
adopting a higher inflation target. But it’s not beyond the realms of possibility that the
Fed and others decide that forcing the issue on 2% might not be worth the pain. As Shirakawa
says: “Inflation targeting itself was an innovation that came about in response to the
severe stagflation of the 1970s and early 1980s. There is no reason to believe it is set in
stone.” The question is one of degrees. If inflation is around 3-4%,
no
one cares
. Central banks would care and still try to squeeze it down to
2% – but at what cost? The marginal impact of rate hikes is already diminishing, how would
another get you from 3 to 2? That would be the question – we are not talking about accepting
5-6% inflation as the new normal. St Louis Fed president James Bullard thinks moving the
goalposts is stupid: “We’ve defined stable prices as 2% inflation. That’s an international
standard that was developed in the 1990s. I think it would be a disaster to abandon that
standard.” Bullard even cautioned “we would be back to the 1970s” if the Fed gives up on its
fight against inflation. Larry Summers, the former US Treasury secretary agrees. “To suppose
that some kind of relenting on an inflation target will be a salvation would be a costly
error, it would ultimately have an adverse effect as it did in a spectacular way during the
1970s,” he said at the World Economic Forum earlier this year. The likes of Bill Ackman and
Mohamed El-Erian have argued for the Fed to ditch its 2% target because the cost is too
high. In December Ackman, the billionaire investor, said the 2% target was “no longer
credible”, adding: “Businesses need price stability, but can thrive in a world with 3%
stable inflation.” Ethan Harris, a Bank of America economist, argues there is little
evidence that the 2% inflation target is the “optimal target”. What’s the difference between
3% and 2%. Not a lot, seems to be the view among many. For others, it’s a matter of
credibility and control – once you admit defeat you let more inflation take off; you might
think you are OK with 3-4% inflation but what then if it accelerates higher again? What do
you think you do then when punched in the face again? El-Erian wrote in an FT op-ed: “The
world’s most powerful central bank is now confronted with two unpleasant choices next year:
crush growth and jobs to get to its two per cent target or publicly validate a higher
inflation target and risk a new round of destabilized inflationary expectations.”
Expectations are the key. As we saw when the Fed adopted average inflation targeting – a
euphemism for accepting higher inflation because it had been low for a long time –
expectations can run riot; the old toothpaste analogy – easy to squeeze out, impossible to
put back in. And what about the dollar’s dominance? Going back to
the Lagarde speech – for multipolarity read decline of the dollar, which would be bad for
inflation dynamics also. The expansion of the BRICS, the Chinese-brokered Saudi-Iran deal,
Russian oil being washed in the East…it’s all pointing to division and an end of the Pax
Americana. The death of the dollar has been talked about many times before and it’s never
happened. I don’t think it’s much different today, but we are already seeing change. Lagarde
borrowed from Hemingway to point out that “fragmentation can happen in two ways: gradually,
and then suddenly”. The dollar accounts for about 60% of global foreign reserves – not much
down on 67% twenty years ago and that is mainly down to the euro. Challenging the dollar’s
dominance is not the same as replacement – one is happening, the other is impossible. But
the challenge is what we are talking about here – the change in the dynamic and increase in
‘fragmentation’. Dollar hegemony was good for trade and for inflation. Lagarde notes: “For
example, the ability of central banks to act as the ‘conductor of the international
orchestra’ as noted by Keynes, or even firms being able to invoice in their domestic
currencies, which made import prices more stable.” At the same time, Western payments
infrastructure became dominant. “But new trade patterns may have ramifications for payments
and international currency reserves,” says the ECB president. For instance, trade relations
have undergone radical shifts in the last two decades. China has increased over 130-fold its
bilateral trade in goods with emerging markets and developing economies. It is also now the
world’s top exporter. Research shows, hardly surprisingly, significant correlation between a
country’s trade with China and its holdings of renminbi as reserves. More yuan means fewer
dollars, it being a zero-sum game. “New trade patterns may also lead to new alliances,”
warns Lagarde. “All this could create an opportunity for certain countries seeking to reduce
their dependency on Western payment systems and currency frameworks – be that for reasons of
political preference, financial dependencies, or because of the use of financial sanctions
in the past decade.” You can read the full tract
here, but in short read more fragmentation on the global scene leading to
multipolarity and the dollar being less dominant. None of which is conducive to lower,
stable inflation. And recent events are only accelerating the trend. US economic sanctions
on countries such as Russia could threaten the greenback’s global dominance, according to US
Treasury Secretary Janet Yellen. “There is a risk when we use financial sanctions that are
linked to the role of the dollar that over time it could undermine the hegemony of the
dollar,” she told CNN. Every time the US deploys its ultimate financial weapon, it
diminishes its power. A more fragmented world means inflation is not about to come back down
to 2% easily. Unless you are Argentina or Zimbabwe you cannot keep hiking forever – central
banks will in the end need to accept, or at least tolerate, higher inflation as the new
normal. Whether mandates are adjusted may be a matter of taste. The effect will be the same.
Or as Huw Pill, the Bank of England’s chief economist, put it, it’s time to just accept we
are poorer.
Group