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)
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