Global
*Global QE, Global Inflation*
July 03, 2009
By Joachim Fels & Manoj Pradhan
<http://www.morganstanley.com/views/gef/team/index.html#anchorjoachimfelsmanojpradhan>|
London
*Inflation complacency:* With headline inflation gauges in negative
territory in many countries and the global economy only just emerging from
the ‘Great Recession', it may seem absurd or at least premature to worry
about inflation risks. Indeed, most investors appear to be undaunted by
inflation, a view that is also reflected in market-implied 10-year inflation
expectations for the US and the euro area of less than 2%, which would be
lower than actual inflation over the past decade. In our view, however,
markets are too sanguine about longer-term inflation risks. It appears more
likely to us that in the coming decade inflation will significantly exceed
the levels seen over the past decade.
*Three reasons to expect higher inflation: *Our inflation view is based on
three pillars, which we discuss in turn:
• We think that most observers vastly overestimate both the size
of the ‘output gap' and the importance of this gap for determining
inflation. Our earlier research has shown that global factors, rather than
national output gaps, are the main determinant of inflation these days.
• The ‘secular' global forces that helped to push inflation lower
or keep it low over the past couple of decades - productivity, deregulation
and globalisation - will likely be less prevalent in the years ahead.
• Quantitative easing (QE) is in full swing globally, and we think
that central banks will be slow to exit from it collectively, especially if
economic growth remains subdued. The longer super-easy global monetary
conditions remain in place, the more likely it becomes that inflation
expectations and actual inflation will start to rise significantly.
*Output gap approach problematic: *The most frequently voiced argument for
low inflation in the foreseeable future is that the Great Recession has
created a huge gap between actual and potential output and thus much spare
capacity that will take years to be absorbed. However, we are inclined to
discount the output gap argument for two reasons:
• First, any real-time estimates of the output gap are highly
uncertain due to data revisions and because estimates of potential output
evolve as more data become available. For example, as work conducted by
Athanasios Orphanides during his time at the Fed has shown, monetary
policymakers' misperceptions about the size of the output gap were a major
factor in the inflationary surge in the 1970s. For a long time during and
after the mid-1970s recession, the Fed believed the output gap to be larger
than it actually was. The reason for this was that it overestimated
potential output, which later turned out to be much lower than initially
thought. In fact, there is reason to believe that the credit and economic
crises of the past year have led to a downshift not only in actual output
but also in potential output. With the end of the consumer and housing boom
in the US, the UK and other countries, resources and excess labour need to
be shifted into other sectors, which will take time and could keep
structural unemployment high. Also, the cost of capital is likely to stay
higher than in the bubble years, and the plunge in capex will contribute to
lower potential growth, too, in our view.
Our more sceptical view on potential output and thus the size of the output
gap is supported by our natural interest rate model, which also generates an
estimate of potential output. Tellingly, our model produces an output gap
for the US that is much smaller than the ‘official' one generated by the
Congressional Budget Office (CBO). Similar results have been reported in a
recent study by San Francisco Fed economists Justin Weidner and John
Williams ("How Big Is the Output Gap?" *FRBSF Economic Letter*, June 12,
2009).
• The second reason why we are inclined to discount the ‘output
gap' argument is that in our previous research we found that output gaps
only have a weak influence on inflation. Rather, global inflation has
become the dominant driving force for domestic inflation rates. If our
estimates are anything to go by, an output gap of 1% pushes inflation down
by barely 15bp in the US (see *Inflation Goes Global*, July 16, 2007).
*Global factors less disinflationary: *So how about the global factors
determining inflation? In the last one or two decades, central banks were
helped in keeping inflation low by a confluence of three factors:
globalisation, deregulation and faster technological progress. However, the
tailwinds for central banks from each of these factors have turned into
headwinds:
• Globalisation is likely to proceed less rapidly in the next
several years due to the creeping protectionism that has been reinforced by
governments' reactions to the Great Recession. Increased support for
national industries is likely to slow restructuring and reduce import
competition.
• Deregulation has been largely achieved in most sectors. Now,
consolidation in deregulated sectors and government-induced re-regulation in
some areas are reducing competition, and thus potentially adding to
inflation pressures.
• The big boost to productivity from the IT boom of the 1990s is
behind us, and trend productivity growth in the technology leader, the US,
has probably slowed significantly. Lower productivity growth that is not
accompanied by slower wage increases implies rising unit labour cost
pressures.
*But monetary policy matters most: *The most important factor for the global
inflation outlook, however, is the current and future stance of monetary
policy. Central banks have responded to the crisis with an unprecedented
amount of monetary stimulus, and we fear that the accommodation will be kept
in place for too long.
*QE is alive and kicking...* The sharp increase in US 10-year yields and
mortgage rates, with 10-year yields reaching 4% in mid-June, led many
investors to question the effectiveness of the QE programme. While a
continued increase in yields would certainly create headwinds for economic
recovery, it is important to keep in mind that keeping yields low was only
one aspect of the programme. As important, if not more so, is the increase
in money supply and excess liquidity. On this measure, the Fed has continued
to run a successful campaign, as have a host of other countries that have
implicitly or explicitly turned to QE.
*...globally:* On our count, the Fed, the ECB, the BoE, the BoJ, the Swiss
National Bank, the Swedish Riksbank, the Norges Bank and the Bank of Israel
all adopted some form of QE around September 2008 (see "QE2", *The Global
Monetary Analyst*, March 4, 2009). M1, the measure of narrow money supply,
has been growing strongly in most of these countries since then. M1 growth
in the G4 is ticking along at 12%, driven by M1 growth of nearly 20% in the
US, around 8% in the euro area, and a move into positive territory for M1
growth in Japan. Outside the G4, money supply is moving up strongly in
Switzerland and Israel, with the latest M1 growth numbers showing 42%Y and
54%Y growth, respectively. The Norges Bank's QE programme has kept the
monetary base at highly elevated levels and M1 growth has begun to shrug off
the effects of previous tightening and is now in positive territory.
Finally, the increase in the monetary base allowed by the Riksbank has
pushed up M1 growth to over 6%.
While there has been no QE announcement from the Chinese monetary
authorities, the efforts made to increase money supply and credit in China
over the past few months have been highly successful. M1 growth has clocked
in at 18.5%Y while loans are growing at 28%Y. India briefly flirted with
QE-type policies (see *India: Flirting with QE*, April 7, 2009) by buying a
sizeable chunk of government bonds since April. However, efforts to push up
money supply don't seem to have been pursued vigorously since then. Both
economies are expected to outperform the global economy. If anything, our
economics team sees the dramatic rally in equities and property as a
development that central banks will have to monitor closely (see *Rise in
Asset Prices: New Challenge for Asian Central Banks,* June 30, 2009).
*More to come: *In the major economies, there is plenty more to come. The
Fed is about halfway through its US$1.75 trillion purchase programme, while
the Bank of England has about 18% (£23 billion) of its programme yet to go.
Meanwhile, the ECB will start purchasing €60 billion of covered bonds this
month. In short, there is plenty of firepower waiting to come out of the
central banks' QE muzzles. If the impact on money supply so far is anything
to go by, we can expect excess liquidity to continue to grow (see "The
Global Liquidity Cycle Revisited", *The Global Monetary Analyst*, May 27,
2009) and support economic recovery and asset markets.
*...but the way out is tricky: *While talk about ‘QExit' has started, we
believe that central banks will most probably not be able to withdraw
monetary stimulus rapidly without putting at risk the tenuous recovery that
our global team expects. On our latest forecasts, the G10 economy will
shrink by 3.5% this year and grow by only 1.3% in 2010. In such a scenario,
central banks are likely to unwind QE and normalise policy rates fairly
simultaneously and very slowly (see "QExit",* The Global Monetary Analyst*,
May 20, 2009), raising the risk of inflation. Importantly, given the
importance of global factors that we pointed out earlier, keeping the
inflation genie bottled up will mean that it probably won't be sufficient if
one or two central banks get the timing of exit right - this is a feat that
a majority of central banks will have to achieve in order to keep global
inflation subdued, in our view.
--
Best Regards,
Jay Shah
"Expect The Unexpected"
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