Markets gear up for an update on Monetary policy

Published at Aug 25, 2017, in Features

Over the coming days we will hear from central bankers in Europe and the US about their plans for monetary policy moving forward. The prevailing belief so far this year has been that a decade of ultra-low interest rates is starting to cause signs of growth in the global economy; and that we will now need interest rate rises to combat against an overheating economy and rampaging inflation.

However, despite some signs of an economic recovery in the developed world (such as low unemployment, and strong asset prices), we are yet to see economic growth and consumer prices (CPI) return to target levels.

Indeed, in Europe they are still continuing with quantitative easing after a round of bad inflation reports late last year. However, it appears that his has led to increases in risk asset prices rather than consumer prices, and Eurozone CPI growth is still languishing around 1.3 percent, which is below desired levels.

In some places, and by some measures, economic growth and inflation are slowly rising, but it is certainly not across-the-board. In fact, CPI growth in practically every developed jurisdiction is weaker than just about everyone’s estimates – especially the inflation bullish central bankers’ models. The only real inflation we have seen is the growth in risk asset prices.

However, despite the obvious lack of CPI inflation, central bankers keep parroting on about it and stating that we will need to see higher interest rates to combat this phantom inflation.

Whilst I agree that high inflation can be a bad thing, and that quantitative easing should be ended. I entirely disagree with raising interest rates solely to combat potential future inflation, as it does not stack up with the wider economic fundamentals we are seeing. In fact, I believe that anyone talking about inflationary pressures on consumer prices is talking about the wrong thing.

The small pick-up economic growth we have seen from the developed world in recent years is likely due to increases in debt levels, which have increased substantially over the last few years with interest rates at historically low levels.

Private debt to GDP

In addition, while private debt levels have increased in many developed nations, wage growth has stagnated. Wages when accounting for consumer price inflation have not increased in the developed world since approximately the late 80’s. In the absence of this growth in wages, a growth in private debt levels has helped to fuel economic growth.

The issue is that if we now see rises in interest rates (as central bankers have been telegraphing for some time); salaries may not have raised enough to sufficiently cover interest repayments at higher rates. Therefore, if we raise interest rates, we are likely to see increased levels of delinquency on debts.

I do not think a sudden attempt to stop phantom inflation is worth risking another credit or liquidity crisis and so I hope that central bankers in the US and Europe will be less “hawkish” in their coming statements.

However, that doesn’t mean I believe monetary policy should be unchanged; as the low interest rates and quantitative easing has created its own problems (such as the growth in debt levels), which will need to be addressed. In the absence of wage growth, monetary policy settings are therefore likely to be a balancing act between growth in debt and debt delinquency rates moving forward – until someone can come up with some better ideas on how to manage an increasingly difficult to finesse global economy.

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