Many economists believe that an extended period of inflation is ultimately the only way out of the low growth aftermath of the GFC. Moreover, the measures needed to stimulate inflation, such as: quantitative easing, negative interest rates, higher inflation targets and commitments to ‘do whatever it takes’, are blunt instruments. Therefore, a degree of overshooting – inflation that is too high – should be expected. Deflation is the immediate danger but investors need to plan today for inflation in the medium to long term.
I never talk about the GFC in the past tense because it is obvious, in the following ways, that we are still living through it:
- GDP growth remains a long way below long term trend growth in developed countries, despite the stimulus of $25 trillion of extra government debt and $10 trillion of quantitative easing.
- Inflation fell rapidly in every major economy in 2014 and early 2015, including China and India. Consumer price inflation settled at close to zero in the US, UK, Europe and Japan in early 2015 and has not changed much since.
- Central bank balance sheets are grotesquely distorted by quantitative easing, as shown below, and total QE continues to grow rapidly.
- Asset prices are in bubble territory in many markets, with prices at historically high multiples of cash flows – especially stocks, bonds and commercial real estate.
Why the world economy has not recovered from the GFC, and how to escape the GFC are the 64 trillion dollar questions. On the first question of why we are still stuck in the GFC, there are two dominant competing explanations – ‘secular stagnation’ and ‘debt overhang’. These are competing explanations but they both point to a burst of inflation being one way out of the GFC, and perhaps the only way.
One group of economists, led by Larry Summers, believes that the GFC and its aftermath should be seen in the context of a long term trend that began in the 1970s or earlier – Secular Stagnation. The meaning of ‘secular’ in this context is that the trend is permanent and not cyclical. ‘Stagnation’ refers to the lack of demand relative to supply of goods and services.
Summers and Co believe that without higher inflation real interest rates cannot fall low enough to stimulate the demand needed for healthy economic growth and full employment. Summers has repeatedly warned the US Fed against raising interest rates before inflation rises, and thereby pushing real interest rates higher. I think Summers is spot on. Janet Yellen’s intention to continue raising rates in 2016, in the absence of USD inflation, is fraught with danger – reckless, really.
Higher inflation would allow real interest rates to go lower which would make monetary policy more effective. With inflation of 5%, real interest rates could fall to minus 2% for an indefinite period.
Another group, influenced by the research of Carmen Rheinhart and Ken Rogoff, point to the history of economic crises that have resulted from a failure of the banking system – just as the GFC did. History shows that such crises follow a clear pattern of: first, many years of high growth in borrowing by firms and households, followed by a banking crisis, followed by a deep recession, followed by 7 to 15 years of slow growth during which households, firms and governments deleverage their balance sheets. Finally, after the long period of deleveraging, normal growth is resumed.
Unfortunately the GFC is following the first part of this historical pattern (massive credit growth in the two decades before, banking failure, economic crisis, low GDP growth) but not the second part (deleveraging). Far from deleveraging, global debt levels have continued to grow faster than GDP. In the Rogoff and Rheinhart framework, economic growth will not return to pre-crisis levels until debt levels fall.
With inflation of 5% or more the real value of global debt, as a percentage of GDP, will begin to fall. A real reduction in overall debt levels would stimulate the global economy because households, firms and governments that have lower debt have a higher propensity to spend on consumption and investment. If households, corporations and governments do not save their way to a debt reduction then only a burst of inflation can achieve the same effect.
Whatever Has to Happen will Happen
Whether Summer’s ‘secular stagnation’ or Rogoff and Rheinhart’s ‘debt overhang’ better explains the aftermath of the GFC – in either case inflation levels of 5% or more offer a way out. For secular stagnation it offers lower real interest rates and for debt overhang it offers lower real debt levels.
Central banks have already employed the extraordinary measures of massive quantitative easing and more recently negative interest rates in their efforts to fight deflation. The European Central Bank recently moved to negative interest rates of minus 0.3% on balances held by commercial banks at the ECB, to get the money out of the ECB and circulating in the economy. Those measures have only managed to stop inflation falling below zero.
But, if inflation of 5% or more is the only way out, then eventually a burst of global inflation is what we will have. If even more extraordinary measures to stimulate inflation are needed then those measures will be taken. That will especially mean ‘talking up’ inflation by central bankers and moving to higher inflation targets to change the expectations of households and firms about future inflation.
Overshooting The key to defeating deflation and inducing substantial inflation is shifting the expectations of households and firms about future levels of inflation. That is because expectations about inflation are partially self fulfilling. Households will only demand higher wages and firms will only demand higher prices if they expect prices to rise.
Unfortunately inflation expectations have been falling in developed economies since the beginning of the GFC. To turn those expectations around – to move them up by 3 or 4% – will take truly extraordinary measures. But those measures are blunt instruments. There is no way to induce inflation with these blunt instruments and to fine tune levels of inflation to avoid overshooting. So, a degree of overshooting should be expected.
What Should Investors Do?
To summarise, many economists believe that inflation of 5% or more in the major developed economies will be needed to escape the GFC. Inducing that inflation will require an application of blunt instruments that means that a degree of overshooting is likely – perhaps quite a lot of overshooting and high levels of inflation in the medium to long term.
In the next newsletter I am going to write about the conundrum faced by investors of navigating short term global deflationary dangers followed by long term inflation. In addition, the likelihood that long term global inflation will be imported into Australia, and what investors should do to prepare.