No investor can afford to ignore central bankers. Their policies and pronouncements have a major impact on economic and market outcomes.
Whenever they hold their meetings, discussion quickly turns to inflation. Most of them are mandated to use their monetary tools to hold inflation steady. From the late 1990s until a decade ago, this seemed to work well. Inflation was low and stable during the era of the so-called “great moderation.” Now, though, fears are resurfacing. Worries about inflation are nothing new; the “great inflation” of the 1970s and 1980s saw soaring price levels across developed economies. What is new is the nature of inflation fretting: the fear that inflation is too low.
In the eurozone, the European Central Bank (ECB) forecasts inflation to be 1.2 per cent in 2019 and 1 per cent in 2020. At the start of this year, it was predicting 1.5 and 1.7 per cent. In the UK, inflation is higher but still below the Bank of England’s target of 2 per cent and currently at a three-year low of 1.7 per cent. Even in the relative global bright spot, the United States, the Federal Reserve sees inflation remaining below target for the next 18 months, despite its recent interest rate cuts.
Persistently low inflation presents two main challenges to central banks. First, it leaves the economy running closer to deflation, or actually falling prices. A falling price level has pernicious effects on the economy—it reduces corporate profits, makes wage rises unaffordable, increases the burden of debt and risks dragging the economy into a vicious cycle. As any negative economic shock to demand has the potential to lower inflation, policy-makers prefer to run inflation so as to provide a buffer zone.
Second, low inflation makes a core tool of monetary policy harder to use. What matters is not the nominal but real rate of interest, adjusted for inflation. In a world of “lowflation,” it is far harder to push down real rates to very low levels unless a central bank cuts nominal rates below zero—which the ECB and the Bank of Japan have been forced to do in recent years.
Policymakers are right to be concerned. Market expectations point towards inflation staying on the floor in the eurozone and the US until well into the 2020s. The UK…