Tomorrow we will hear from the Chancellor about his fiscal plans and, given the recent loss of the UK’s AAA rating, George Osborne is not likely to be able to announce any relaxation of fiscal policy.
Impact of loss of BoE inflation control
As such the burden of supporting the economy will remain largely on monetary policy and there is a great deal of speculation that we could get some changes to the Bank of England’s remit. Any loss of control of inflation through monetary policy by the Bank of England’s has to be a concern for sterling fixed interest investors. Away from that it will be interesting to see whether there are any new proposals for using the central bank’s balance sheet to get credit flowing to the real economy more directly, which I think is the next big challenge in the post-crisis world.
At the very least the Bank of England is very close to restarting QE and if the recent industrial production numbers are anything to go by the economy certainly needs more help.
The fact is that economic growth is not strong enough anywhere to allow the fiscal adjustment to take place easily. There is no guarantee that it will be any time in the foreseeable future either. In many economies the level of GDP is still below where it was at the end of 2007 and deleveraging is still taking place.
Given that outlook is it realistic to conclude that the great monetary experiment is over? It would be surprising if central bankers did not get closer still to the Rubicon. If we are to believe Bernanke and Yellen in the US the Fed may want to see the economy operating at full capacity with a higher inflation rate before they even think about tightening policy.
Get cash working
In Japan a revolution of the political establishment is taking place to enshrine the 2% inflation target. In the UK, the post-1992 progress on reducing inflation and inflationary expectations could start to be undone under the guise of ‘nominal GDP targeting’. In the eurozone the letter of the Treaty of Economic and Monetary union might be tested if the ECB wants to reduce economy-wide interest rates further.
The upshot of this is that if it works investors should seek higher-yielding assets and inflation protection. Reflation has to involve increasing the velocity of money which means dissuading people from holding cash or near cash assets like government bonds. To get people to spend money more quickly there has to be a threat to its value being debased.
If there is an expectation of rising prices then money loses value, thus higher yielding financial assets or consumption should be preferred to holding cash. This policy is only successful when growth recovers to at least its estimated potential and inflationary expectations are convincingly higher.
I can see it working in the US and thus see some upward drift in US treasury yields – although the extent to which yields can rise when the Fed is still buying $40bn of treasuries a month is limited. Inflation remains low for now, but this is when investors should buy inflation protection. There is evidence of spending picking up and investment picking up and companies showing some signs of animal spirits. Washington could still do damage to this recovery but hopefully it won’t.
