Central bankers won’t tell you – but they’d like inflation to be higher

Jerome Powell © Getty Images
What if the Fed’s Jerome Powell really is more hawkish than anyone thinks?

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Investors get bored quite easily, I’ve noticed.

A new story comes around and it looks good. They put money on it. It doesn’t materialise within five minutes. They throw their hands in the air like a sulky teenager and march off to something else.

That’s why they don’t make as much money as they should.

The latest story to incur their frustration is the inflation comeback. US ten-year Treasury yields – poised until recently to rise above the magic 3% level – have now slipped back to around 2.8%.

So is this loss of faith reasonable?

I don’t think so.

Why central bankers should be aiming for higher inflation

Niels C Jensen, who writes The Absolute Return Letter (and has just written a book, The End of Indexing, which I haven’t read yet but fully intend to) is always an interesting commentator.

It’s also always nice when an intelligent person independently agrees with your own view, so I thought I’d share his take on the “big picture” outlook with you, mainly because I agree with it (yes, I know that’s some serious confirmation bias in action, but at least you know what you’re getting).

As Jensen reminds us, the world is still very indebted. Indeed, he argues that we haven’t yet really recovered from the 2008 financial crisis. In order to get back to full health, we need to destroy debt. “I would argue that debt destruction is the only way for a society to start afresh, when the ship is about to sink.”

There are only two ways to do that (ie, destroy debt rather than actually pay it off). You either default on it – you just turn around and say you can’t pay – or you inflate it away – you pay it back, but you pay it back with money that’s worth less than the money you borrowed in the first place. It’s like defaulting, but it’s the sneaky, tactful way to default.

Which hurts more? Well, it depends on who you are, to an extent. But one road leads to deflation and the other – obviously – to inflation.

Default is the deflationary option. If everyone turns around and tells their creditors to whistle for the money, that is pretty devastating. Credit availability tightens right up. Banks go bust. Unprotected savers can lose the cash they thought was safe, and nobody can borrow money, even for worthwhile projects.

It’s all very messy and it forces the economy to shrink. This is what happened in both the Depression and in 2008. So as 2008 is the most recent catastrophe to be visited upon us all, it’s the one that’s freshest in mind and the one that everyone wants to avoid a repeat of  (it’s why we printed all that money after the financial crisis, after all).

What about inflation? Well, that’s the route we took in the late 1960s and throughout the 1970s to 1981, notes Jensen. (You can read more on the 1960s parallel here).

Putting it bluntly, the 1970s were no picnic for investors. I wasn’t there for half of it and I was too young to have any idea of what was going on for the rest of it. But I don’t get the impression that it was fun. (Here’s a piece on just how bad the bear market got).

Nevertheless, says Jensen, your average central banker is likely to prefer the 1970s rather than the 1930s as a way out. “A bit of inflation will most definitely do some damage, but it won’t take the global economy down, like a re-run of 2008 could possibly do.”

(It’s also worth noting that they’re less likely to cop the flak for a 1970s-style outcome, whereas they would definitely be derided for 1930s-style outcome, which most academics blame on the US Federal Reserve tightening monetary policy too quickly).

In order to destroy debt via inflation, prices have to rise more rapidly than interest rates.

And as Jensen notes, as well as destroying the debt by repaying it with devalued money, rising bond yields would “suddenly bring a very sick defined-benefit pension industry back to life, which would lift a huge burden off government’s shoulders.”

That’s why central bankers – in theory – will be keeping their fingers crossed for inflation to keep rising. They’ll aim to “stay behind the curve” – in other words, they might keep raising rates, but they’ll try to make sure they don’t actually choke off inflation.

So it would make perfect sense for Fed chair Jerome Powell, the Bank of England’s Mark Carney and the rest of the world’s central bankers to try to keep a higher inflation target in mind (although they’d never tell us that, of course).

It would be a big surprise if the Fed turned hawkish

As always with markets, of course, there’s a bit of a fly in the ointment.

What if central bankers – and Powell in particular – aren’t on board with the plan? What if Powell really is more hawkish than anyone thinks?

In that case, reckons Jensen, we’d be looking at a deflationary bust in the short-term (rather than the long-term, which is where Jensen thinks we’re still headed – I’m not so sure on that, but that’s for another day).

My own view is that hawkishness seems unlikely, and even if Powell is hawkish right now, it’ll be knocked out of him at the first setback.

What does Donald Trump want? Low interest rates, a rising stockmarket, and probably a weak currency. What does the institutional memory of the Fed currently fear most? The Depression and deflation.

I’d be very surprised if Powell can resist all that. And why should he? At this point, there is no real happy ending for the Fed. Might as well put the bust off for as long as possible.

So despite the recent drop in US Treasury yields (which was driven, I suspect, largely by investors having grown too excited about the idea of selling off Treasuries, thus creating a temporary contrarian opportunity to buy back in), I’m sticking with my view that inflation will be at the heart of the next crisis.

When that happens to roll around, on that I’m not so sure. But I’ll be keeping a close eye on the indicators that will tell us it’s heading our way.

  • Timothy Stroud

    Not being an economist, I wonder if the central banks know what they are doing.
    The Americans are well on the way to wholesale bankruptcy, by using debt, and borrowing, and unfunded tax cuts, to pump up insane levels of spending on their
    military. The Chinese do not seem to have noticed, or maybe they do not care.
    It is all very odd. Trump just wants to be re-elected in 2020 – everything else is secondary.

  • Andrew Crow

    A curious headline.

    Central bankers have been musing out loud for a couple of years or more about the non appearance of inflation, which they expected. As indeed have many supposedly eminent economists.

    Both have studiously ignored the inflation in asset prices and senior salaries and persisted in pretending it was going to trickle down into the high street shopping basket.

    Did this fool anyone ? I can’t imagine why.

  • Gary

    I have been of this opinion that the BofE has been doing its best to stoke inflation for a long time. I think inflation is a lot higher than is being reported. The basket of items monitored is constantly changing to facilitate this and packet contents are reduced in size by supermarkets.

  • Mark Tyson

    I do wonder why everyone talks about “the next crisis” as if one is compulsory. If you look at the last one hundred years as a time frame you will find that crises on the scale of the two we have seen in the last 20 years are quite rare. A bit of recency bias in contemporary thinking?

  • Gerry Hutchinson

    Oh dear! Another completely unsubstantiated ‘five-minute’ item which means precisely nothing! The US has, at the last count, something like $20 trillion worth of debt – well over the recommended 60% of GDP! It does not take a genius to work out that their economy is totally dependent on Chinese levels of saving but also that a debt crisis will recur. Despite all the recriminations over the 2008 meltdown, the capitalist system is built on the presumption of sustainable debt. Debt is supposed to allow investment and the return on that investment provides the wherewithal to pay off the debt. Does anyone seriously believe that the US, the world’s dominant economy is going to pay off their debt with inflation? What we will see is worldwide economic meltdown with a recurrence of 2008 style bank failures and government takeovers. It won’t happen immediately but if the US continues on the path of fantasy tax-cutting and Trump will of course be re-elected, I would guess we’ll be back in the same old scenario in five or ten years’ time.

    • ufewl ufewlx

      as long as 5 years?

  • ufewl ufewlx

    John Stepek assumee anyone who agree with him is intelligent of course, I would say equally stupid.

    • ChrisF

      No he doesn’t. “It’s also always nice when an intelligent person independently agrees with your own view”. He makes no claim as to his own intelligence, or lack of it. Try to keep up.

      • ufewl ufewlx

        He only the only reason he thinks they are intelligent is becasue they agree with him, more the case they are equally stupid. His logic is patently stupid.

  • GMAC

    The whole reason central banks talk about being scared of deflation is an excuse to cause inflation which is the only way governments can afford to keep deficit spending… some minor countries like Greece and Italy may eventually default on/restructure their debt but I doubt if there will be a wholesale “debt jubilee” a la Porter Stansberry’s “The American Jubilee”… more likely a forgiveness of things like “student debt” and a few “car loan defaults” but inflation is definitely my preferred outcome… hence investment swing towards quality retail stocks, disrupters and commodities like nickel, cobalt and lithium or better still gold and preferably silver @ 80:1.

  • FriarStuck

    Central bankers and politicians should be jailed for what they are doing.

    There has been price inflation, in assets, particularly housing that has made life for those without those assets very difficult indeed.

    Productivity is slowly being destroyed by the asset price inflation, because it’s now much easier to make money from paper gains in asset prices than it is doing anything productive, it is also the same gains in asset prices that make productive enterprises so difficult to be profitable or even get going in the first place (i.e. prices of land and rents have inflated to levels way beyond the ability of ordinary people to afford them)

    Governments are lying about the GDP numbers, the UK for example, now estimates drugs and prostitution in this number, as well something called “imputed rents” making up an ever larger proportion of the figure.

    The economy since the mid 2000s has become a zero sum game where those with assets control an ever larger percentage of a pie that’s slowly shrinking, parasitically propped up by central bank easy money and deficit spending from politicians (THERE IS NO AUSTERITY).

    A mass debt default is the only honest way out of this, and if left purely to the market, unhindered by meddling from central bankers and politicians, could be resolved in two years at most (as the panic of 1920-1921 shows).

    The politicians won’t do this though, because them and their donors are the holders of assets propped up by this tragic farce, and given another decade or so of slow destruction of the productive economy, price inflation, even with heavily massaged figures will start affecting prices in the shops (it has been mitigated so far by shrink-flation, or the use of ersatz and unhealthy substitutes in food, for example fructose corn syrup, rather than cane sugar).

    If easy money and deficit spending continues beyond this, destruction of the currency system via a hyperinflation event, is the final outcome, and is something I don’t really want to live through.