The Bond Market Is Wrong. Inflation Will Return, Someday.
August 25 2019 - 10:29AM
Dow Jones News
By James Mackintosh
The bond market thinks central banks are out of juice and
inflation will stay below target for, well, ever. The longest-dated
Treasurys are priced for inflation to average 1.6% for the next 30
years, and German bonds for just 1.3% inflation. Both are testing
the lows of 2016, when the oil price crashed and investors feared
deflation.
To believe inflation will stay very low for a very long time
requires believing both that the Fed and other central banks really
are running on empty and that governments won't offer fiscal help
to counter a downturn or recession. The first has a kernel of
truth, but central bankers aren't entirely out of gas, especially
in the U.S. The second requires investors to believe that the past
decade's fiscal austerity is a better guide to the future than all
of recorded history, when politicians were only too eager to spend.
There are already early signs of a shift in political and economic
thinking, too (more on this later). In short, inflation will be
higher than the bond markets currently expect.
It is clear that the conventional tools of central bankers no
longer have the oomph to tackle the deflationary power of a
recession. In every recession of the past half-century the Fed cut
rates by at least 5 percentage points, but with rates at just 2%,
the power of cuts is limited. The situation in Europe and Japan is
even worse, with rates already negative.
Unconventional tools helped rescue the world from the 2008
financial crisis. But Europe and Japan have failed to get inflation
up to target in spite of deploying, between them, almost the full
set: bond-buying, caps on long-dated yields, purchases of corporate
and some bank bonds, forward guidance, long-term low-rate loans to
banks, negative yields and even buying stocks. Almost everything on
the handy How to Fight Deflation list set out by then-Federal
Reserve Board Gov. Ben Bernanke in 2002 has been tried, and while
neither the eurozone nor Japan has falling prices, they are nowhere
near 2% either.
The market clearly doesn't think the Fed will have any more luck
when it rolls out similar tools, as it surely will if interest
rates are still this low when the next recession hits.
But there is one important tool left. It is immensely powerful,
and investors are ignoring it. The strongest central bank
instrument is the direct financing of government spending or tax
cuts, dubbed "helicopter money" because it is economically
equivalent to an airdrop of cash. If anything has the power to
boost inflation, this is it. The danger is that once it starts,
it's hard to stop (it's also illegal in Europe, although actual
airdrops of bank notes might be allowed).
Where bond investors are right is that central banks will only
engage in helicopter money if they really have to, because it is
politically contentious, threatens their independence and is hard
to calibrate.
Yet, the idea is going mainstream. Earlier this month three
former senior central bankers now at BlackRock, the world's biggest
fund manager, proposed a variant that would provide conditional
central bank support for extra fiscal spending. Jean Boivin, former
deputy governor of the Bank of Canada; Stanley Fischer, formerly a
Fed vice chairman and governor of the Bank of Israel; and Philipp
Hildebrand, who ran the Swiss National Bank, think that creating an
institutional framework for supporting government spending would
make it easier for the central bank to retain its independence and
withdraw support when inflation returned.
The idea has merit, although it skims over the problem of how to
get a gridlocked Congress to agree in advance on details of the
spending or tax cuts to be deployed in a crisis.
There are also plenty of signs that governments might themselves
respond, helping central banks in their mission to accelerate
inflation. The U.S. is already running an enormous deficit, and
more tax cuts were briefly considered last week to aid the economy.
Even German politicians have been discussing spending some of their
fiscal surplus (though not actually running a deficit). Sajid
Javid, Britain's new chancellor, said he was thinking seriously
about how to take advantage of the low cost of government debt. An
actual recession would surely encourage them further.
Finally, there is the question of whether central banks will
retain their independence. President Trump on Friday intensified
his Twitter assault on the Fed, calling Chairman Jerome Powell an
enemy. Proposals by New York Rep. Alexandria Ocasio-Cortez to force
the Fed to finance a "Green New Deal" have garnered support on the
left wing of the Democratic Party. If there's a recession and the
Fed proves impotent, the pressure on the central bank from right
and left will only increase.
Taken together, it is implausible to think inflation will stay
superlow for decades. Either central banks and the government will
work together, or central banks will be seen to have failed and
lose their independence. Japan shows how even extreme action can
fail, but Japan allowed deflationary expectations to become
embedded before it finally got serious.
The trouble for bond traders is that it might take a crisis --
and the threat or reality of deflation -- to generate the political
pressure needed to make big changes. It's plausible that we will
get much lower inflation and bond yields before governments and
central banks take the radical steps needed to bring inflation
back, perhaps explosively.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
August 25, 2019 10:14 ET (14:14 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.