Investors continue to have some strange obsessions when assessing the outlook for growth, inflation and resulting US policy responses. Ben Bernanke’s fairly anodyne comments in a TV interview last week on the need for harder empirical evidence to verify that the US economy is on a sustainable growth track sparked the markets into a renewed obsession with QE3. The dollar fell and bonds rebounded on speculation that the Federal Reserve would soon print even more money.
These fairly self-evident remarks persuaded investors that 10-year bonds were a bargain at yields of about 2.25%. And yet these same bonds were yielding 3.5% a year ago when QE was in full swing and core inflation was a full percentage point lower than it is today. Inflation is now clearly above the Fed’s newly-announced 2% target and is heading higher, yet this seems to cause no concern among investors. Instead they prefer Bernanke’s standard reassurance, repeated last Friday: “As always, we have to look at inflation and be comfortable that price stability will be maintained and that inflation will be low and stable." But the fact is that inflation has already moved out of the “low and stable” range, as currently defined by most central bankers – and this is true in the euro zone and Britain, as well as the US. Even accepting the Fed’s definition of “core inflation”, the annual increase in CPI excluding food and energy was 1.1% in February, 2011, but is now 2.2%. This is already above the Fed’s self-imposed 2% inflation target and the trend is clearly upwards (see chart below). The same applies to every other definition of core inflation shown in the same chart. And assuming that the US economy does accelerate further, as the Fed is hoping, it is hard to see why the inflationary trend should suddenly reverse.
Meanwhile, inflation has also accelerated in the euro zone, where the latest core CPI is 1.9%, up from with 1.1% a year ago – and even in Japan, the core rate of deflation has risen from -1.3% to -0.5%. In fact, the only major economy where inflation has slowed in the past year is Britain – and that was only because of the partial reversal of a huge overshoot caused by last year’s VAT hike (see last chart).
There are two rational responses to these figures and one that is clearly irrational. The first rational response is to worry that inflation will become a serious problem for the world economy in the years ahead, which should not be surprising given the enormous monetary and fiscal expansion. A second rational response would be to argue that 2% inflation targets are too low and that central bankers all over the world are now secretly aiming for higher inflation, perhaps around 3% or even 4%. This policy was recommended two years ago by the IMF’s chief economist. And it makes some sense, both because higher inflation targets would give policymakers more leeway before interest rates hit the zero bound and also because faster inflation – especially when it is not anticipated by markets – reduces the burden of public and private debts. The response to recent inflation trends that is not rational is simply to ignore reality and assume that exceptionally low inflation rates of the last decade will return. It is worth recalling that, even in Germany, inflation never averaged less than 2% during any ten-year period before 1999. Investors should pay less attention to the words of central bankers and more to their actions. These suggest inflation well above 2% will become the global standard in the years and decades ahead. And this is yet another reason to remain wary of bonds at this stage.
Anatole Kaletsky and panel of economists will be presenting at a GaveKal Research seminar on 16 April 2012 at the Bloomberg Auditorium, 39-45 Finsbury Square, London, EC2A 1PQ from 3pm to 6pm, to discuss Strategies on the Global Economic Outlook, covering the G20 and emerging markets, including the UK, Europe, US, Japan, China and Asia.
Any Red Blog reader is invited to register to attend this seminar for free. Tea, coffee and biscuits will be served at the event and all attendees will receive a copy of GaveKal's Quarterly Strategy Chart Book, published this month.