Central Bank Regime Change: who cares about 2% inflation targets anymore? A chart.

For those clients who received our Panoramic fixed interest newsletter in December (the latest edition is out now by the way, with a detailed analysis of the global high yield market), you will have seen that I talked about Central Bank Regime Change as one of the key issues for fixed interest investors in the coming years.  What I meant by Central Bank Regime Change is this: the days of Central Banks caring too much about inflation are behind us.  We’ve had three decades since Paul Volker took over at the Fed and set interest rates above the rate of inflation (a novelty at the time), and we’ve had independence granted to the Bank of England, and seen inflation targets of 2% become commonplace.  From here on in though, Central Banks will care about two things – unemployment and debt.

Charles Evans of the Chicago Fed is the only person who will publicly say it (admitting you don’t care about inflation anymore isn’t such good news for your government bond markets), but getting the unemployment rate down aggressively must be the priority for the authorities, otherwise we are doomed to structurally low growth and social unrest.  If this means inflation overshoots that 2% level, he is relatively relaxed about that (3% would be very acceptable).  And an inflation overshoot helps the developed world’s other big problem – debt.  There are three ways to shrink an excessive debt burden. You can grow your way out of it (but with broken banks, austerity and high unemployment, below trend rather than above trend growth looks more likely – look at Greece).  You can default on state liabilities to your populations (this is happening) or to your bondholders (less likely for regimes with their own currencies).  Or you can set negative real interest rates and erode the debt burden through stealth inflation.

And this is the regime under which we are operating.  The IMF put together part of the chart below – I’ve added the most recent period post the Great Financial Crisis.  You can see that before the Second World War there was a wide range of real interest rates in the UK, with little pattern.  For much of the period the UK was on the Gold Standard with fixed exchange rates.  The period also includes the Great Depression where we experienced deflation.  After the Second World War the UK emerged with a Debt/GDP ratio of over 200%.  You can see that most of the next three decades was spent in low real rate environments, with periods of negative real rates.  With financial repression making UK banks hold gilts, and some modest growth, the debt burden was aggressively eroded.  The Volker years show a step change in real interest rates to sharply positive rates.

The final normal distribution curve shows the world we live in now.  Since 2008 real rates have been sharply negative (justifying the unusual negative real yields on virtually all inflation linked bonds).  Remember that no person in authority will ever be able to admit to regime change, but all of us have to understand it’s happening.  What it might not automatically mean though is that we are in a big bond bear market.  First we have to identify a regime (negative real rates), then understand whether the market is pricing that regime correctly (no, yields are too low) – but then you have to apply any structural overlays which might override your thoughts on fundamental valuation.  And it’s here that Quantitative Easing becomes important.  As Charlie Bean of the Bank of England’s MPC has stated, QE reduces “the cost of financing a given deficit”.  Here in the UK, the Eurozone and the US, Central Banks are keeping bond yields low enough to stop their governments from going bust – and that’s not going to change for the foreseeable future.

Discuss Article

  1. ZLD says:

    When debt loads are too large there are two possible solutions:
    1) Money is transferred from debtors to savers (debt is repaid)
    2) Money is transferred from savers to debtors (debt is defaulted on, or eroded through inflation)

    1) is a recipe for depression unless the savers start to dis-save and offset the loss in consumption from people paying down debt.
    2) runs the risk of moral hazard if it becomes too widely accepted, plus it reduces incentives to lend pushing up the cost of credit and weighing on the real economy.

    So real defaults hurt the economy, as lenders withdraw credit.
    Paydown hurts the real economy unless savers dis-save (analogous to countries with a current account deficit trying to close that gap when those with a surplus refuse to adjust).
    The least painful option is inflation/repression whatever you want.

    Its not just the easiest solution, it may well also be the best (for the economy as a whole).

    Posted on: 15/03/12 | 3:43 pm
  2. Justin Pugsley says:

    Relatively mild inflation will do most of the heavy lifting when it comes to reducing debt as a share of GDP as there is little public appetite for ‘real’ budget cuts like in Greece.
    Then there’s the paradox of quantitative easing – on the one hand it acts as a kind of guarantee to gilt prices that they won’t be allowed to fall too far, a variation on the famous Greenspan put? After all the BOE could in theory buy every Gilt in existence and some and potential short sellers must be aware of that.
    On the other hand QE is debasing the currency, it drives commodity inflation and pumps up equities so we have the strange and unusual sight of regular big rallies in oil, gold, equities and bonds all at the same time, when the former two rallying should be bad for the latter two asset classes.
    How will all this end? Very hard to say, but if QE starts to seep out of financial markets into the real economy in a big way (which you would expect eventually) then for central banks to put the genie back in the bottle could be very expensive in terms of mopping all that liquidity up through much higher interest rates, which no one can afford to pay including the government.   

    Posted on: 15/03/12 | 3:44 pm
  3. FT Alphaville » Further reading says:

    […] Who cares about 2 per cent inflation targets […]

    Posted on: 16/03/12 | 8:08 am
  4. Nick says:

    Who gives the BoE the right to decide to transfer wealth from savers to debtors?

    Surely this is not moral and it is not within their remit.

    What if the BoE had increased the IR and kept inflation low? Perhaps that way the House prices would have been corrected and the economy would grow.

    Posted on: 16/03/12 | 9:04 am
  5. pater tenebrarum says:

    I couldn’t agree more with what Nick said above. Moreover, the proposition to ‘lower the debt burden via inflation’ is very dubious. It may not work as long as there is a free market for government debt, as the market could ‘take away the printing press’. Inflationary policy is only attractive to policymakers as long as the frog can be boiled slowly, but not when the market realizes what is happening and the demand for money suddenly plunges (usually these events are ‘non-linear’ as they say). 

    Posted on: 16/03/12 | 11:45 pm

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