- ERIN SCOTT / Reuters
- The economy – with full employment and sky-high stock markets – is screaming for an interest rate rise. But the US Fed and the ECB have signaled they’re going to cut instead.
- Why are we living in a Bizarro World where an overheating economy generates low inflation, and central banks shovel ever more cash into an on-fire market?
- US Rep. Alexandria Ocasio-Cortez touched on the issue in a recent hearing: “Unemployment has fallen three full points since 2014 but inflation is no higher today than it was five years ago.”
- That’s because we have solved inflation. It is no longer a problem. Macro deflationary forces are more powerful than central bank monetary forces.
- The next issue is whether governments will be willing to take advantage of the extra fiscal spending space this historic opportunity presents.
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The economy in Europe and the US is an unusual beast right now. We have full employment, extended GDP growth, and the stock market is through the roof. The S&P 500 has breached 3000, the Dow is at 27,000, and the FTSE 100 is at 7530 – all at or near all-time highs.
Normally, these conditions would be screaming for an interest rate rise. The economy ought to be overheating, inflation ought to be spiraling, wages ought to be going up, along with demand, and employers should be struggling to find extra workers and resources to fill their order books.
But the opposite is happening.
The European Central Bank just concluded that it needs to “be ready and prepared to ease the monetary policy stance further” after failing, again, to goose inflation up to its 2% target.
- Focus Economics
In the US, Federal Reserve chair Jerome Powell also signaled he will cut rates. “There is a risk that weak inflation will be even more persistent than we currently anticipate,” he told Congress.
So what’s going on? Why are we living in a Bizarro World where a powerhouse economy generates low inflation, and central banks shovel ever more cash into an on-fire market?
The old relationship between employment and inflation is broken
“Unemployment has fallen three full points since 2014 but inflation is no higher today than it was five years ago,” she said in a congressional hearing with US Fed chair Jerome Powell [see mark 2.06.30].
“The economy can sustain much lower levels of unemployment than we thought without troubling inflation,” Powell responded.
That, really, is the headline here: inflation no longer exists.
We should be living in the Weimar Republic. But we’re not.
Inflation is gone.
Even 10 years of interest rates set near zero no longer generates consumer price increases. The textbooks of the early 2000s said we should be living in the Weimar Republic, or Zimbabwe, right now. Instead, house prices in London have been in decline for more than a year.
Inflation has been solved. We solved it, through our new inventions.
The macro effect of all this “solving” is a permanent downward pressure on prices – which is good for workers who don’t want their wages eaten away by inflation (but bad for workers who want nominal pay rises).
That notion that inflation is extinct is not obvious
In a note to clients last week, Nomura analysts Rob Subbaraman and Andrew Ticehurst said: “Major central banks seem trapped in an era of ultra-loose monetary policy. Very low interest rates for an unusually long period of time involve diminishing returns and rising costs that make normalisation of monetary policy increasingly difficult.”
They worried that the “problem” of low inflation would create “a loop that makes it even harder to normalise.”
A low-inflation, low-interest rate environment can definitely create problems:
- Asset price bubbles (stocks, property) disproportionately benefit the rich and increase inequality;
- the overall level of debt increases as its quality declines;
- and large investors will foolishly mis-allocate ever-more cash in dangerously illiquid investments, in their search for yield.
But low inflation brings opportunities, too.
In a deflationary world, fiscal policy – government spending – is more important than monetarism
Governments now have more fiscal “space” to invest and build.
“In countries with fiscal space, it should be used more forcefully to boost sustainable growth, especially spending on worthwhile things like infrastructure, education and R&D,” Nomura’s Subbaraman and Ticehurst said. They are part of an ever-noisier chorus of investment bank analysts begging governments to wake up and smell the money.
Now is the time to spend. Not just to create inflation (and avoid deflation, which can be even worse). But to build the energy, transport, defence, health, and education infrastructure we will need for the future. Low cost debt makes this spending cheap.
It’s a rare, golden opportunity for governments (and an intellectual defeat for conservatives).
Hopefully, they won’t squander it.