No fear in a new era of inflation

ECB and Federal Reserve commitments to open-ended policy easing will likely result in a period of rising inflation that should be welcomed, not feared.

When the people who can do whatever it takes to engineer a pick-up in economic activity say that they will do whatever it takes to engineer a pick-up in economic activity, it is time to listen and prepare for it.

For the first time in many years, there is a growing and well-founded optimism about the outlook for the global economy that is being driven by the "do whatever it takes” policies announced in the past week or so from the European Central Bank and the US Federal Reserve. The prospects for the global economy are more favourable today than even a few weeks ago because of the policy action.

It is time to prepare for a period of rising inflation and higher asset prices.

The basis for this game changing assessment is the unprecedented open-ended policy easing from both the Fed and the ECB. To put it crudely, these two central banks are all but saying that money will be printed and printed and printed until economic growth picks up and the unemployment rate falls. In moving to this position, their actions suggest that the ongoing economic sluggishness is untenable.

Without being too cynical, the policy changes must be potent because those complaining about them and especially their open-endedness, are the dark suited monetarists who for the last 25 years have been shadow boxing an inflation demon that only exists in their minds or quaint text books. For some reason, these people think the current low inflation rate in the US and eurozone, the huge amounts of spare capacity and the chronic unemployment matter little or are a price worth paying in an effort to keep inflation below some arbitrary target.

It is possible I have missed it, but I have not seen nor heard too many of the 30 million or so people unemployed in the eurozone and the US complain too much about open ended QE. Nor have those with huge negative equity in their house taken to the airwaves to complain about easier monetary policy. I suspect that these people, the victims of the recession, are not too concerned by the prospect of inflation hitting 3 per cent for a short period, as they struggle to arrest the downward spiral in their living standards.

These are the very people, of course, that the policy changes are directed at. QE will lower borrowing costs for business, provide ample liquidity and will deliver a calming market influence as it works its way through the economy. In time, easy policy will support activity and with that jobs and some inflation will come.

The US and eurozone, and therefore the world economy, might be about to break out of its disinflationary funk. A little bit of inflation, on a temporary basis, would be no bad thing.

Inflation raises nominal incomes, company profits and tax revenue for the government. A year or two of 3 or 4 per cent inflation while the economy eats away at the spare capacity and gets unemployment down would also help, at the margin, contribute to a bottom line improvement in fiscal imbalances lowering debt to GDP ratios.

Even in these dire economic times, no-one sensible is advocating a permanent change in the inflation target to a higher level. It is still best, when the recovery has traction, to recalibrate policy to meet an inflation target of 2 per cent over the medium to long run. But that is still some way off. Let’s see the growth first, lower unemployment second and then worry about whether there is a legitimate inflation problem to tackle.

There is some evidence that the market now gets this brave new world of policy. US stocks not only surged immediately after the Fed announcement, but rather unusually extended those gains to the following day with a further rise of around 0.5 per cent. Other stock markets are similarly buoyant.

There are other snippets of market news that are consistent with more favourable prospects in the year ahead.

Commodity prices have moved higher. The Reuters/Jefferies CRB index of commodity prices have risen almost 20 per cent in US dollar terms since the recent low in late June. In euro or Australian dollar terms, the rise has been a still impressive 15 per cent. At the same time, longer dated government bond yields have moved higher and yield curves have steepened. German bond yields are no longer negative.

Obviously it is early days and these policies will not fix all the problems of the US and eurozone for many months, even years. But on top of earlier policy action, these radical and unequivocal policy actions are more likely than anything we’ve seen to date to provide the framework for stronger growth in the year ahead.

Ten out of ten for Mario Draghi and Ben Bernanke.


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