Mike Tyson’s one liner “Everyone has a plan until they get punched in the mouth” comes to mind when I think of the predicament central banks must confront these days. The plan is, and has been, to keep interest rates low for an extended period. While the punch in the mouth is the building up of long-term inflationary expectations.
A lot of real and virtual ink has been spilled recently via pundit commentaries and media reports dreading the effect that the massive fiscal stimulus programs, on both sides of the border and around the world, could have on inflation. Experts link this fear to the selloff in global bond markets and the rapid increase in bond yields in the first quarter of 2021.
It’s reasonable to expect that after the pandemic, the impact of adding enormous buckets of government spending to fast recovering economies and pent-up demand will stimulate economic growth, driving inflation in the short term. But, is this what bond markets worry about, or is it the building up of long-term inflationary expectations? I believe it’s the latter.
I believe long-term inflation will rise due, primarily, to productivity, taxation and structural changes. We may be reaching a peak in productivity growth as retiring baby boomers with decades of experience are replaced by less-experienced employees who’ll nevertheless be in high demand because of low-population growth. These younger will demand higher wages and this will likely mean higher inflation down the road.
I predict, pandemic-related deficits and ballooning debt will encourage governments to increase taxation. Many have likened the ongoing coronavirus crisis to a war. The pandemic, like the two world wars of the last century, has been expensive. And, as did those conflicts, it will require higher taxes to address the related deficits and accumulated debts. The fireworks have started in this respect as the British press announced that the U.K. had announced its biggest corporate tax hike in decades.“The amount we have borrowed is comparable only with the amount we borrowed during the two world wars,” said Rishi Sunak, the chancellor of the exchequer, in a media report. And I think other Western countries will likely have to adopt similar measures.
A possible pause of globalization could trigger higher inflation, as companies, trying to guard against supply-chain interruptions, will likely be bringing production back to North America, characterized by a higher-production cost environment. Whereas historically central banks have acted in a counter-cyclical fashion, in the past 10 to 15 years the central banks have been almost singularly dedicated to increasing the money supply, and this will no doubt, in my opinion, intensify long-term inflationary pressures.
Since the 2008/09 recession, the U.S. money supply has been growing at an annual rate of 13 per cent. In 2020 alone, the money supply increased by an incredible 51 per cent. In this context, it’s worth remembering that the rampant inflation of the 1970s was caused primarily by monetary policies, which were designed to finance massive budget deficits. Finally, even if the response to the credit crisis of 2007/08 through aggressive quantitative easing (bond buying by the central banks) didn’t produce higher inflation, it was only because quantitative easing was basically offset by banks and individuals deleveraging their balance sheets. But nowadays, I believe there’s an overaggressive quantitative easing program without any counterbalancing effect and this, too, could lead to higher inflation.
To interrupt the trend toward higher long-term inflation, central banks may attempt to drain liquidity out of the economy by raising interest rates. But, how would the markets, the politicians and central bank governors react? What will they do if a full-blown crisis erupts? The Nasdaq and emerging market equities have already declined by more than 10 per cent between mid-February and mid-March of 2021 because of such fears and this may be a prelude of things to come. Will central bankers and politicians panic and rush to offer solutions that include lowering interest rates and increasing liquidity?
The power of the markets has grown in recent years. As of 2019, the assets of funds worldwide totalled US$89 trillion, more than three times the combined US$25 trillion balance sheets of the biggest central banks. We’re in an age of tyranny imposed by the capital markets.
Monetary authorities and politicians alike seem to respond to the whim of the markets rather than the other way around. This became evident in 2013, when markets forced the U.S. Federal Reserve System to reverse its plans to start withdrawing stimulus. And then again in late 2018, when then-U.S. President Donald Trump encouraged the Fed to keep interest rates low. The Fed responded and cut interest rates rather than raise them.
But can they afford to do this this time around, considering the building up of long-term inflationary pressures described above? In my opinion, they may have run out of both bullets and time. This conundrum will have serious implications for the markets, particularly for the high-growth stocks that have propelled the market higher in recent years.
George Anathassakos is a professor of finance and the Ben Graham chair in value investing at Western University’s school of business. These views are those of the author and not necessarily those of the Canadian Investment Review.