Richard Buxton: Should central banks target inflation at any price?

Buxton Richard Old Mutual

Stockmarkets have had much to contend with since the start of the year. Apart from the obvious candidates of a falling oil price, worries over a US recession and a slowdown in China’s growth, a new concern has emerged. Has monetary policy as a means of stimulating economies reached the end of the road?

The reaction to the Bank of Japan’s recent move to join the club of those central banks offering negative interest rates does provide food for thought. Crushing sovereign bond yields, creating ever flatter yield curves, has started to appear counterproductive. They raise significant concerns about bank profitability. They undermine confidence in the ability of life insurance companies to meet long-term savings promises.

Financial shares worldwide have weakened significantly year-to-date. It is hard to see how this is going to encourage “animal spirits” in boardrooms, investment and higher bank lending. If monetary policy post-financial crisis has been an exercise in increasing risk appetite among investors, companies and individuals, have we not reached the point where yet more “stimulus” has the opposite effect of driving confidence ever lower?

Seemingly unrelated to central bank activity are three further issues: demographics, technology and shifting patterns of demand. We live in a world of ageing populations, from the US to China, with India and Africa being notable exceptions. Older generations spend less, save more and certainly buy less “stuff”. Producers and retailers could always rely on the younger generation to be a reliable source of demand but today’s younger generation is less interested in buying “stuff”. This “generation rent” has no desire for fitting out their first flat with furniture.

Meanwhile, technological change and the move to the digital world are playing their part. The constant upgrading of one’s hi-fi system, so beloved of my youth, is redundant in the world of the iPhone and Spotify. And of course companies are facing disruptive challengers that are almost universally disinflationary through eroding pricing power and margins. So put together a world with significant excess productive capacity, demographics and technological change with “peak stuff”, and central bankers’ determination to raise inflation to their 2 per cent targets looks like a big challenge.

Plunging interest rates and bond yields ever lower into negative territory as a means of generating demand and inflation seems to me to be increasingly flawed. If lower bond yields are now counterproductive by undermining confidence in the financial system, perhaps central banks should rethink.

Might it not be better for confidence if bond yields (and, indeed, even interest rates) were to gently rise? Labour markets in the US, the UK and even parts of Europe do not suggest the economies are about to sink into recession. Does the world actually need more stimulus? Or just more confidence?

Certainly, a number of company chief executives we have met recently do not understand why equity markets are so panic-stricken as they see nothing as yet to justify the sell-off. Life is tough and competitive but not as bad as the febrile markets of recent weeks would suggest.

One idea: instead of negative interest rates make all the G7 central banks adopt twin targets for both growth and inflation, like the US Federal Reserve. Inflation targeting alone is policy orthodoxy from the scars of the 1970s inflation years. Over very long periods of time, stable or gently falling prices are more usual than the experience of the second half of the 20th century.

Twin targets would signal to bond investors that policymakers were still vigilant about inflation were it to arise but not at any price. Gentle moves upwards in bond yields would reassure nervous investors the financial sector was not going to be crushed by a world of no yields. And that could do wonders for confidence.

Richard Buxton is head of UK equities at Old Mutual Global Investors