In research from economists at a number of international institutions, there is a major shift occurring in thinking about how monetary policy is conducted. This shift could prove crucial to the outlook for inflation, so it has profound implications for investors.
For several decades, the major central banks of the world have been very successful in achieving sustained low inflation. That allowed both short-term interest rates and long-term bond yields to fall sharply from early 1980s levels.
However, in 2008, when the world was on the verge of the biggest financial crisis since the 1930s and the biggest global recession in decades, inflation and short-term interest rates were historically low. This quickly highlighted two problems that now seem to be troubling researchers.
Firstly, with inflation already low, the recession soon had the major economies teetering on the brink of deflation. If we look at the US experience, even a typical recession tends to reduce the inflation rate by 1.5 to 2 percentage points, and the 2009 recession was far from typical. Secondly, with official interest rates already low, the central banks soon hit the zero boundary, effectively running out of their traditional ammunition to stimulate economic growth, so quantitative easing was born.
In the past, central bankers have largely run monetary policy by shooting for one objective (low inflation) using one policy instrument (short-term or overnight interest rates). In most cases, low inflation has been defined as an annual rate of consumer price inflation of around 2% or so. In Australia in the early 1990s, our Reserve Bank decided to opt for a higher and more flexible target of 2% to 3% inflation over the course of an economic cycle. This was often viewed less than favourably by the strict inflation regimes of Canada and New Zealand, where inflation targets of 2% or less were adopted. Ironically, the Australian regime now looks far more robust: Australia did not experience a recession or deflation, and monetary policy was able to boost growth without having to resort to quantitative easing.
With the GFC experience in mind, some respected research economists, including researchers at the Federal Reserve Bank of San Francisco and Olivier Blanchard and others from the International Monetary Fund, are taking a different view on monetary policy. They have suggested that for monetary policy to help combat stubbornly high long-term unemployment, or to be able to respond to a financial crisis, central banks might have to tolerate higher than normal inflation for longer periods or raise their inflation targets. This would raise – rather than lower – the average level of short-term interest rates.
While this might be perfectly sensible from a policymaker’s point of view, for investors it is potentially a major worry, because higher inflation is the mortal enemy: it eats away at our real income and wealth, lowering our purchasing power.
Just how prepared are markets and investors for a period of higher inflation if it were to occur and indeed to be sanctioned by policymakers? The answer is ‘not very’. At current bond market valuations and interest rates, it would mean that conservative investors in fixed income and term deposits could suffer an extended period of negative real returns.
If higher inflation is part of our future, investment strategies designed to generate reliable and real returns over time, with a strong focus on actively managing risk, will be extremely valuable.
