Friday, July 21, 2017

Monetary policy and inflation

Recent inflation in advanced capitalist countries remains subdued, despite the expansionary monetary policy that has dominated major economies.. As Guy Debelle from the RBA argues that "four common global factors that have led to the expansionary monetary policy settings seen in most advanced economies for almost a decade".

They are: the global financial crisis, low levels of corporate investment over the past decade, low wage growth and low inflation. 

The fourth and last common factor is the sustained low inflation that has been evident globally for the past decade (Graph 2). This is a direct consequence of the three previous factors I have just talked about . In addition to those influences, there has been a continuation of the disinflationary pressure resulting from the integration of China into the global economy. There are signs that this latter force might be waning, with producer prices in China actually growing, following many years of continual, often quite substantial, declines. Throughout the past decade, expectations about future inflation have remained broadly anchored, which, at times, has helped stave off a shift towards deflation, but currently may be dampening the prospects of a sustained pick-up in global inflation.

He concludes: 
The effects of these global influences on the Australian economy have been material. The global economic environment and global policy settings that have been in place for the past decade have contributed significantly to the monetary policy settings in Australia that we have today and will likely continue to do so for the foreseeable future. 
Currently, financial markets don't expect any further lowering of policy rates in the major economies, nor any further expansion in policy settings. Hence the downward pressure on domestic policy settings from this source does not look like it will intensify in the foreseeable future. But the four common factors that are highlighted in the first half of my speech are still present. While there are some tentative signs that they are abating, the evidence is inconclusive at this stage.  
As I said earlier, the Federal Reserve has raised its policy rate very gradually four times over the past two years. And last week the Bank of Canada increased its policy rate to 0.75 per cent. Just as the policy rate in Australia did not need to decline to the very low levels seen in other parts of the world, the fact that other central banks increase their policy rates does not automatically mean that the policy rate here needs to increase. The policy rates in both the US and Canada still remain below that in Australia. 
Ultimately, in Australia as is the case elsewhere, policy rates are set at the level assessed to be appropriate to achieve the domestic policy objectives. While global influences, including monetary policy settings in other economies, have a significant impact on that assessment, they are, in the end, only one of a number of considerations to be taken into account.
Longer-term structural changes will affect overall inflation/deflation more than the vagaries of individual commodity markets. Chinese overinvestment leading to declining production, in the context of eventual debt deleveraging (and perhaps crisis) could overwhelm the world economy and all variables such as inflation.

Mix that with a spike to the stock bubble in the US as the Fed tries to get to more 'normal' monetary policy and the world's two major economies could go pear shaped. The Fed is likely to reverse any return to normal as the consequences of the initial shift - begin. Meanwhile, Europe has Germany running a record current account surplus meaning it has to export capital and import demand from countries that need that demand. Southern Europe remains in turmoil with political reaction increasingly likely.

If China and Japan try to export their way out of their problems, Germany doesn't start exporting demand, and the US is increasingly wary of continuing its role as the global consumer of last resort, then where are those exports going to go?

The interesting variable is a possible Trump stimulus. He's going to have to do something to avoid registering an even lower approval rate. The sort of stimulus that would work best - advantaging lower and middle income households - is the least likely because Trump believes in trickle down - fix up the rich people and everyone benefits! A Trump stimulus will also mean the Fed will try to return to normal monetary policy more quickly

Notwithstanding this Trump caveat, I'm not sure we have to worry about rising interest rates over the medium-term. Asset price deflation in the context of the attempt to get back to normal will expose the fragility of business investment and the excesses of household debt. The possibilities of deflation outweigh the possibilities of inflation.

On a rosier front, employment in Australia is holding up, which means the coming collapse in consumption has a little way to go.


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