What’s happened to inflation?
One of the defining themes of late 2016 and early 2017 was the idea that developed economies would move out of a period of monetary easing and stimulus…
And into one characterised by Government spending, tax cuts and other fiscal measures.
This would be deployed to directly stimulate the real economy and spending, thereby relieving central banks of the burden they have carried for much of the last decade.
That sounded fine in theory, and was welcomed by bankers, who were already saying that monetary policy had, or was reaching the limits of what it could achieve.
The subtext of that being: if left unchecked, unconventional monetary policy (QE) would start to produce negative returns and consequences.
The idea of the move to fiscal stimulus was reinforced by the campaign promises of both US Presidential candidates, who saw the need to repair and modernise America’s crumbling infrastructure as an opportunity to win votes, stimulate the economy and create jobs.
Though in hindsight neither candidate said too much about how this would be paid for – quite an important detail when the sums being discussed numbered as much as a trillion dollars.
But, as Mark Twain said, never let the truth stand in the way of a good story.
It was good story, because alongside fiscal stimulus there was to be a normalisation of interest rates and a return to growth, which would be symbolised by the return of inflation.
Inflation was bugbear of the boom/bust economies of the late 20th century, but is now just the thing to show newly invigorated economies are making headway.
But here’s the thing…
Five months into the Trump presidency and we have heard nothing concrete about spending, apart from the idea of building a border wall with Mexico, of course.
That project has all the hallmarks of a white elephant in the making, not least because the US Federal Government owns hardly any of the land on which the wall would need to be built.
Elsewhere, European economies (with the obvious exception of Germany) remain in the grip of post-crisis austerity and so have not been in a position to spend money to develop their domestic economies, even if the fiscal compacts of the Euro would allow them to so.
Ironically the Germans, who could afford to splash out thanks to their ever increasing surpluses, choose not to because they believe in a financial discipline that does encourage “lavish gestures”.
As was noted above, one of the signs that things are normalising in Western economies was to be the return of inflation.
But apart from the UK, none of the other major developed economies has found a mechanism that attracts excess demand or rising prices into their economy.
UK inflation is running at just over two percent, currently in line with the Bank of England’s target. But ironically, nothing the bank did directly brought this about.
Rather, it was the work of the British public – who voted for Brexit and, in doing so, created a 12% plus devaluation in the value of the pound.
Britain is a trading nation of course, so any changes in exchange rates are a double edged sword. Our exports become cheaper to foreign buyers, but imported goods become dearer to us in Sterling terms.
Those price rises create inflation, but when inflation is created on that side of the street, it’s not demand-led and it doesn’t equate to growth.
In fact it can have the opposite effect. However that negative influence should be offset, and hopefully outweighed, by increased levels of exports.
And if the economy is efficient, then over time the market should create a domestic supply of previously imported goods and allow for an expansion of production to meet the extra demand for our exports.
Whose problem is it anyway?
Of course, Eurozone members are not able to adjust the value of their currency independently, because the Euro is controlled by the European Central Bank (ECB) and not by individual member states.
And in Europe, we have yet to see politicians take the plunge and implement fiscal stimulus. Even with a dramatic change in administration in France, following Macron’s election win, it may be some before we do.
Simply because, whilst QE is being implemented, stimulating the economy is not the politician’s problem – it’s the ECB’s.
EU inflation data for April 2017 showed a pick up in the rate of price rises. Indeed, core inflation in Europe rose to 1.2%, its highest reading for almost four years.
So you might think it was time for a pat on the back for the European Central Bank.
But not so fast… because part of their mandate is to create sustainable growth and inflation.
Unfortunately for the ECB, that is not what is anticipated to happen by the markets.
The chart below (courtesy of Thomson Reuters Datastream) plots Eurozone inflation expectations five years hence (orange line).
In other words, these are investor expectations for Eurozone inflation in 2022.
But, as you can see, having rallied throughout 2016, those inflation expectations have been steadily declining since the turn of the year suggesting that markets are losing faith in the ECB’s ability to create a Europe-wide sustainable rebound.
All roads lead to Vienna…
The chart above also plots the price of Brent Crude oil in blue and, as you can see, over this time frame there appears to be a relationship between the two lines.
Now it would be too simplistic to say that Eurozone inflation is solely determined by the price of oil, as there are many contributing factors to the inflation numbers.
But oil prices do influence investor expectations about inflation in Europe, not least because the Eurozone is an oil importer with little or no production of its own.
So, in the continued absence of a switch to fiscal stimulus and an end to QE, we may find that the ECB and Eurozone political establishment are secretly wishing for further hikes in the price of oil following OPEC’s forthcoming meeting in Vienna on May 25th.
I’ll have more news on that meeting tomorrow, so keep an eye on your inbox.
That meeting is also the topic of conversation at a very special event Agora Financial UK are holding exclusively for you.
At this event, you’ll learn the significance of the meeting and what possible effects the outcome (whatever that may be)could have on the markets…
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