Market Economics | Interest Rate Strategy - BNP PARIBAS ...

Brazil’s 50bp rate hike this week was insufficient to
meet the challenges of an economy well beyond
capacity and rising inflation expectations). With
monetary policy likely to remain soft and with global
commodity prices under upward pressure, what
central banks say and what they do are not
consistent. Further, people’s experience of higher
inflation, especially of food, is likely to push inflation
expectations up.
This will not be welcome in many countries. But in
the US, higher inflation expectations are probably a
policy goal. Clearly, inflation expectations are low
and falling. Clearly, there is massive excess capacity,
especially in the labour market. Clearly, wages are
weak and so are unit labour costs. Therefore there is
a real and present danger of disinflation and even of
deflation. Interest rates are at their zero lower bound
and, despite QE, there seems to have been a
‘liquidity trap’ like behaviour of long-term yields – with
the central bank unable to get them low enough to
bring the economy back to full employment.
So how is the Fed to avoid disinflation? The
traditional means is to narrow the output gap
sufficiently to end the threat. But the gap is too wide.
Moreover, since the ability to lower short-term rates
is gone and the ability to lower long-term rates
enough is lacking, the output gap will stay wide. So
the main means of fighting inflation is to raise
expectations of inflation down the road. Firms and
individuals expecting inflation at a future date, when
spare capacity is reduced, will price differently and
act differently today. That is what “considerable
period” was about in 2003 and it’s what QE2 is about
today.
In short, to overcome deflation today, look as though
you will create inflation tomorrow. It’s like telling
central banks facing deflation that the responsible
thing to do is to be irresponsible. There are plenty of
people who think QE2 is irresponsible – the Chinese,
for example. You can criticise the Fed for pursuing a
policy that will create inflation the day after tomorrow.
But if the alternative is deflation today, is that such a
bad policy?
While the threat of disinflation remains real in the US
– which is to say while payroll growth remains
insufficient to significantly lower unemployment and
while wages and pricing power remain subdued –
then it would be wrong for the Fed to do anything
other than to create expectations of future inflation.
Thus we would expect that policy to persist “for an
extended period”.
The Fed’s ability to create inflation in the domestic
economy is limited by the slackness of the labour
market. Because of this and the fact that what people
experience is an important part of expectations
formation, it follows that to create expectations of
inflation, it has to create expectations of inflation in
import prices. In other words, the Fed probably wants
to see global inflation high at present, or a weak
dollar, or both. We can argue that an increase in oil
prices is the “wrong sort of inflation” since it “taxes”
consumers, but if the choice is between the wrong
sort of inflation and deflation, then the Fed would
probably take the former.
The Fed has made explicit that its aim is to raise
inflation, because US inflation is too low. If countries
peg or dirty float against the USD, they are implicitly
adopting a target to raise their own inflation rates.
Since their inflation rates are above the US and in
some cases already too high, the implication is that
we should expect inflation expectations in their
economies to rise.
Summary
• The global output gap is very small and may
have closed. We look like going well beyond
capacity in the next couple of years. The fact that
capacity utilisation is very uneven raises the
global inflation threat;
• Commodity price shocks are likely to continue
due to the lagged effects of La Niña and global
warming, though next year some of these effects
may decline;
• Monetary policy on a global basis is too slack,
especially in Asia. US policy is amongst the
slackest. While this is appropriate for the US,
exchange rate arrangements may mean this is
imported into inappropriate settings such as
EMs;
• Inflationary expectations are very low in North
America. Elsewhere, they are moderate to high.
The objective of the US is to avoid deflation by
raising inflation expectations. Countries limiting
the appreciation of their currency are importing
the Fed’s objective of raising inflation.
• The risks of global inflation are high. Capacity is
tight, monetary policy is slack and central banks
are acting weak. The discipline of pegging to the
reserve currency is gone from much of the world
because the reserve currency has an ultra-easy
policy and is aiming to raise inflation. The risk of
a surge of inflation and a dislocation of inflation
expectations is high in many countries; and
• The key thing to watch is inflation expectations.
They have declined from their ‘scare’ levels last
year but the wild swings over the last couple of
years show they have become unstable.
Paul Mortimer-Lee 20 January 2011
Market Mover
8
www.GlobalMarkets.bnpparibas.com