The following article originally appeared in The Financial Times on April 3, 2013.
By Andreas Utermann,
Allianz Global Investors
The inflationary challenges of the 1970s created a touchstone for the generation of senior central bankers that oversaw monetary policy across the OECD from the 1980s onwards. The orthodoxy that emerged was characterised by money targeting, development of maximum inflation policies, central bank independence and an environment in which countercyclical monetary policy (known as “leaning against the wind”) was anathema but where erring on the side of caution translated into attempting to be “ahead of the curve” by anticipating inflation.
Since 2007, though, we have seen a generational and regime change at OECD central banks, and the old orthodoxy has given way to a new set of norms.
Whereas central bank balance sheets within the OECD were broadly stable in the decades before 2007, they have since exploded. The Bank of England’s has expanded by about 500 per cent, the US Federal Reserve’s by 380 per cent, while the formerly much more conservative European Central Bank follows not far behind at 250 per cent. Despite protestations that this expansion can be sterilised and has not yet led to expansion of broad money aggregates because of the collapse of velocity, this probably relegates money targeting to the dustbin of history.
Central bank independence, once so important, is now being subtly but perceptibly eroded as governments find their fiscal room for manoeuvre increasingly constrained. The old division between the organs of monetary and fiscal policy is starting to blur. This is visible in both the explicit financing of government debt and in the greater receptiveness towards central banks “leaning against the wind”, an approach previously frowned upon as beyond the scope of monetary policy.
Meanwhile, maximum inflation targets are being adjusted upwards and minimum inflation levels set. The former is on the cards in the UK while Japan has introduced the latter as it looks to finally extricate itself from the economic doldrums. Consequently, erring on the side of caution now means central bankers being reactive rather than proactive on the inflation front – or behind, not ahead, of the curve.
The emergence of this new orthodoxy has a number of significant implications for investors.
While inflation expectations look well anchored for the next 18 months, the medium-term consequences of central banks willingly being behind the curve would be a pick-up in broader measures of money supply as velocity recovers, and rising inflation expectations. Already in the past decade, inflation has surprised on the upside, with G7 inflation systematically underestimated by consensus. Rising inflation expectations will make sovereign bonds at their current, artificially subdued yields even less attractive to investors, intensifying financial repression as a means to silently de-lever. This can only raise the spectre of a big bond market correction and encourage investors to look elsewhere for positive real returns. In this type of economic environment, with low but rising inflation rates, equities have historically outperformed bonds.
The prospect of inflation expectations catching up with reality will also affect wages and, by extension, equity sector valuations. Except for the periods after the dotcom bubble and bust and the financial crisis, employee salary costs as a proportion of net corporate productivity in the US have been trending downwards since 1980. Based on a historic correlation between this metric and consumer inflation, we can expect a reversal of this trend as wage growth responds to higher inflation expectations. This could become an increasingly important factor for the valuation of labour-intensive businesses.
All other things being equal, we can also infer from the new orthodoxy an impact on currency movements, and in particular on real exchange rates. Aside from the day-to-day oscillations, the real trade-weighted progression of major currencies since 2007 is highly correlated to the expansion of central bank balance sheets, with sterling weakest and the yen the strongest. The aggressive quantitative easing policies across most of the OECD have had the effect of bringing a much swifter (downward) adjustment of real exchange rates relative to emerging economies.
Seen in this light, rather than partaking in a currency war, Japan is now (belatedly) falling into line with other developed economies to halt and ultimately reverse the ever appreciating yen. This is part of an important rebalancing of the global economy and supports the continued appreciation of emerging markets currencies, notably the renminbi, over the coming decade.