Bear with me. This starts nerdy but leads somewhere important.
A recent paper from the Finance and Economics Discussion Series, published by the US Federal Reserve, provides compelling evidence of the important role that a recovery in inflation expectations played in the 1933 recovery from the great depression. It shows that only when economic participants’ inflation expectations recovered did the economy recover. It supports the idea that what matters to economic growth, through the mechanisms of capital expenditure and consumption, is not confidence but instead the expectation that if you don’t invest or buy today then it will be more expensive to do so tomorrow.
Actual inflation and inflation expectations are not the same thing at all. All things being equal, we would like our economy to grow quickly and sustainably but we don’t really want prices to rise. Rising prices make people poorer, so if we were to design perfect conditions, we would want inflation expectations to stay reasonably high but actual inflation to be low.
To this extent, quantitative easing has turned out to be a policy of truly extraordinary – if perhaps unexpected – genius. Economic participants believe that it is inflationary and act accordingly: after all, the central bank is apparently printing money!
Whereas the truth is rather different: it is probably at least inflation-neutral and potentially even deflationary or disinflationary. The argument for it being inflation-neutral is that, while the monetary base increases, there is a natural rate of growth for the economy anyway, based on demographics and productivity, so more money just means it doesn’t need to circulate as quickly. Economists call this lower velocity and it is clearly prevalent in the economic data seen since the beginning of QE programmes.
What’s more, I actually believe that QE is deflationary. I know this sounds radical but it makes sense if you have read Joseph Schumpeter. He talked about a “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one”. His theory which he terms “creative destruction,” even though the term is originally used differently by Marx, is that capitalism thrives through a process of renewal, through old businesses and industries that have become uncompetitive being replaced by new businesses.
By keeping borrowing costs lower than they should be, by making money more easily available to borrowers than it should be and by lowering the cost of capital, central banks are allowing inefficient businesses and dead industries to stay afloat. Ultimately this process should lead to excess capacity: more goods and services being produced than are needed to be consumed. Higher supply than demand leads to lower prices, thus deflation or disinflation. Drilling for oil doesn’t look to be a great business – returns have always been pretty low – but cheap capital has meant that there’s been a lot of oil drilling. The result is falling prices.
QE has thus been a grand illusion, creating or sustaining inflation expectations while also keeping prices under control: the goldilocks outcome. Now, it looks like we are entering a new regime for Fed policy in which the balance of inflation management and demand management requires tighter policy. The Fed’s own optimal control forecasts suggested hikes this year and it looks like it will deliver.
History has taught us the importance of keeping inflation expectations strong and stable though. For me, that means the Fed will likely continue to sound dovish on the prospects for future hikes throughout this rate cycle. That doesn’t mean they are. That doesn’t mean they won’t be hiking regularly. It just means that they are waving their magic wand – creating a new grand inflationary illusion.
John Ventre is head of multi-asset at Old Mutual Global Investors.