I have known Prof. Goodhart since Cambridge days, when he read my draft on European Monetary Union on a visit at the London School of Economics. I think he will be proven right about inflation.
Coronavirus: Which countries will harness the great disruption?
Debt levels exploded in 2020 and a battle royal now looms over how sustainable the global easy-money settings will be.
In the dying days and hours of Congress’ tense last-minute pre-Christmas rush to pass yet another blockbuster pandemic fiscal stimulus package, one senator almost derailed the show.
Patrick Toomey, a Republican from Pennsylvania, insisted he wouldn’t support a $US900 billion ($1.2 trillion) COVID-19 relief bill if it didn’t include withdrawing some emergency Federal Reserve lending powers.
The Fed’s facilities were granted by Congress as a temporary backstop after the pandemic sent financial markets into meltdown in March. They were due to end by the end of December but the new bill extended their lifespan.
“These are unprecedented, extraordinary powers, and they’re only justifiable in a real emergency,” Toomey said on December 21. Continued use would result in “tremendous political pressure to misuse these” powers, he added.
With American households and businesses screaming for financial relief as the coronavirus wave devastates families and threatens to plunge the US economy into a double-dip recession, Toomey eventually relented and agreed to water down his opposition.
But the Senator’s brinkmanship over the Fed’s ability to pump more emergency liquidity into financial markets looks to be an early skirmish over what will almost certainly become one of the toughest political battlegrounds in 2021; the political economy of debt and deficits, both in the US and elsewhere.
With debt levels exploding around the world, driven by a tsunami of cheap money, ultra-low interest rates and central bank quantitative easing – more than one in every five US dollars in existence was created in 2020 alone as the money supply grew by more than 20 per cent — governments will be under staggering pressure to use those funds for all manner of spending.
Politicians have acted in ways that would have been unthinkable just a year ago, with the result being the sort of profound shift in economics seen when Keynesianism gave way to Milton Friedman’s monetarism in the '70s and when central banks were set free in the '90s. Where this new era of economics leads remains to be seen but what is certain is that once the spending horse has bolted, it will be difficult to rein in.
Toomey indicated he was trying to remove such temptation from the incoming Joe Biden administration – suggesting the new president would pressure the Fed to misuse the facility. And that the Fed would be too weak to resist.
Where he got that idea from is hard to know for sure, but one clue might be in the past four years of Donald Trump's relentless bullying of Fed chairman Jerome Powell into delivering ever lower interest rates.
In any case, Biden and Democrats will be eager to ramp up debt-funded spending over the next four years, with the President-elect promising to unleash a $US2 trillion green infrastructure package.
But he will be under pressure to go even further from more ambitious progressive Democrats, eager to copy the example of Trump-era Republicans and spend money, cost be damned.
“No one asks how we’re going to pay for the Space Force. No one asked how we paid for a $US2 trillion tax cut. We only ask how we pay for it on issues of housing, healthcare and education,” Alexandria Ocasio-Cortez told American 60 Minutes in December. “For me, what’s unrealistic is what we are living in right now.”
One Australian observer familiar with both the Obama administration and Trump, having worked for both presidents as an adviser on manufacturing, is Andrew Liveris. He says the lack of inflation and low interest rates means governments like Biden’s must invest in ways that don’t just support hedge funds or venture funds but are for the public good.
Liveris believes the new administration will soon deliver an “FDR moment” or a grand bargain in which taxes are raised to retool and boost America’s economy. “It won’t be the green deal, but there will be a new deal and the pay-fors for the new deal will occur because money is so cheap,” Liveris tells AFR Weekend.
He says opportunities abound, including on climate change, but also in reskilling America’s workforce and improving transport and mobility. “I do think you’re going to see a revamp of America’s crucial capability, and that’ll create employment,” he says.
Unlike during the Trump years, when business was very much in the President’s ear – winning, for example, historic company tax cuts in 2017, under Biden it will be “a government-driven agenda”, Liveris says, focused on the pandemic, racial inequality and rebuilding roads and airports.
“We really do have a need for an agenda in place that’s driven by government ... and I think that’s where Biden is going to rule from.
“How can you argue about helping people who have been left behind by the economy that has allowed the rich to get richer and people who avoid tax? That mantra is not just Elizabeth Warren’s. That is at the centre of the Democratic party.”
Even Republicans are likely to support that agenda, Liveris believes. “Say you’re a Republican and represent a part of the country that needs better roads and better airports, it’d be very hard to push back.”
Lower for longer
Such optimism will soon be tested, particularly if Republicans retain their Senate majority after the run-off elections in Georgia on January 5. Mitch McConnell demonstrated during the Obama years that he’ll resist anything that helps the Democrat administration.
For Australia, the loosest monetary policy in the country’s history is underlined by a roaring sharemarket and rebounding residential property prices – paradoxically when the economy is just beginning to recover from a deep recession. Household wealth hit a record $11.35 billion in the September quarter, with average wealth reaching $441,649 per person.
David Orsmond, economics professor at the Macquarie Business School and a former Reserve Bank of Australia official, says the interest rate outlook has extended from “lower for longer” in the wake of the 2008 global financial crisis to “lower for even longer” since COVID-19.
“Asset prices will generally be higher as a result,” Orsmond says. “There is a question about managing assets prices when there are low interest rates and extensive liquidity.”
Grant Samuels Fund Management adviser Stephen Miller says Australia has done “extraordinarily well” on the economic and health front, compared to the rest of the world, since COVID-19 struck in March.
But he points to three risks from the ultra-low interest rate environment – excessive risk-taking by investors, rising asset prices exacerbating wealth inequality and the possibility of a surprise inflation jump.
“Let’s pat ourselves on the back how well we’ve managed the journey so far, but let’s not pretend the journey’s over with a vaccine. There are these medium-term chickens that may come home to roost.”
Miller, who has worked in bond markets for much of his career, understands why the RBA has been forced to engage in a “zero sum” currency devaluation game against other central banks.
“Central bankers are all playing this game,” he says. “The Fed’s easy money for several years leaves the RBA with no choice but to follow. If the RBA did not do so, the Australian dollar would be more overvalued and make us less competitive.”
The RBA has cut the overnight cash rate to 0.10 per cent, committed to buying more than $100 billion of government bonds and set up a $200 billion cheap funding facility for commercial banks. Nevertheless, the Australian dollar rose above US76¢ before Christmas, partly because the iron ore price soared to at least $US176 a tonne.
The aggressive asset purchases by other central banks across the world have driven down sovereign bond yields and put upward pressure on the Australian dollar – a headwind for local exporters and import-competing businesses.
Hence, market expectations are building that the RBA will extend its six-month, $100 billion government bond-buying program beyond April.
RBA governor Philip Lowe has also committed to keeping the cash rate anchored at 0.10 per cent for “at least” three years.
Miller says people will need to be acutely aware that an extended period of record low borrowing costs could create a “moral hazard” by increasing the risk of financial instability. “We’ve got to be careful not to encourage excessive risk-taking through free money.”
Orsmond says banks and financial regulators will need to be on alert. “It could mean extra bank stress testing and more detailed supervisory both within the lending institutions and regulators.”
Miller also sees implications for wealth inequality, including younger generations who are struggling to get into home ownership and are less invested in the sharemarket.
“Monetary policy has inflated the price of financial assets, with very little impact on spending. Free money has led to a disconnect between Wall Street and Main Street and extenuated wealth inequality,” he says.
A more activist government fiscal policy may be required to target the wealth distribution issues that a blunt economy-wide monetary policy cannot address, he says.
Miller also cautions that the very low borrowing costs are keeping alive struggling “zombie” firms and inhibiting natural “creative destruction” that helps underpin the economy’s productivity.
“By not allowing markets to work to penalise undisciplined risk-taking, we’re perhaps permanently lowering the growth path of the economy, diminishing its flexibility and dynamism,” Miller says.
And there is the key question of whether and when inflation will return, a question posed by The Economist’s front cover in December.
In the short term, high unemployment means it appears unlikely that a wages-induced inflation spike is imminent. Oil prices are low and strong US shale oil supply that can be quickly ramped up if there are shortages in the Middle East also provides a safety valve.
Long-running structural forces like more competition from the globalisation of the labour and goods market, the digitalisation of the economy and excess savings among older people in Asia are also adding to deflationary pressures.
But in the post-pandemic world there will be factors that could add to inflation. Supply chains will be less global as countries look to “onshore” some fundamental manufacturing capabilities in health and technology and become less dependent on an unpredictable China.
Central banks have made clear they will be more tolerant of inflation. This would help governments and households inflate their way out of massive debts.
Once vaccines are distributed, there is a possibility that stimulus-fuelled consumers will unleash their pent-up demand on supply-restricted industries affected by COVID-19. Prices might rise in some industries.
Crying wolf on inflation
Former Bank of England board member Charles Goodhart and former Morgan Stanley global economics head Manoj Pradhan ask in a research paper “what will happen when the lockdown gets lifted and recovery ensues, following this period of massive fiscal and monetary expansion? The answer, as in the aftermaths of wars, will be a surge in inflation.”
To be sure, theirs is a minority view. And Miller admits people like him have been “crying wolf” on inflation for years. “But we should remember that the wolf turns up in the end,” he says.
In the meantime, Biden and investors more generally can expect further support from the Federal Reserve and central banks around the world. At its final meeting for 2020, Fed officials indicated they saw no chance of rate hikes until 2023 at the earliest, and announced additional bond-buying plans.
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