Macro Battleship with Christopher Wood

The worlds of politics and central banks are increasingly converging, just as fiscal and monetary policy have long since started to converge in the conduct of quantitative easing. This is because the G7 central banks are themselves becoming increasingly overtly politicized.


Did Independent Central Banks Really Defeat Inflation?

The word, “overtly”, is used deliberately since the reality is that central banks in the G7 developed world have never really been truly independent. Still an axiom of the Keynesian-monetarist orthodoxy, which has dominated macro policy making since the early 1980s, is that central bank “independence” was a key driver of the defeat of inflation in the late 1970s and the subsequent decline in short- and long-term interest rates which has been the dominant trend ever since.

The federal funds target rate peaked at 20% in June 1981 and the 10-year Treasury bond yield peaked at 15.8% in September 1981. This historical interpretation gave far too much credit to the central bankers as a collective group.

The reality is that the defeat of inflation in America was primarily attributable to one truly independent central banker, Paul Volcker, who was willing to raise the federal funds rate by 11ppt in the period between August 1980 and June 1981 and so defeated inflation which at its peak in America was running at 14.8% in March 1980. At the peak of Volcker’s tightening cycle, real interest rates in America were, by today’s standards, a remarkable 9.3% (see following chart).

U.S. Real Fed Funds Rate Deflated by CPI Inflation

Source: Federal Reserve, U.S. Bureau of Labour Statistics

The Causes of the Continued Decline in Inflation

If Volcker was the man who defeated 1970s-style cost-push inflation, the subsequent decline in inflation for the next nearly 40 years can, in my longstanding view, be primarily attributed to secular themes, some of which can be viewed as good and some as bad.

Globalization has clearly been a major driver, though it now looks as if it has peaked as reflected in the fact that trade is no longer growing faster than the world economy and has not been since 2012 (see following chart).

Whether globalization is good or bad depends on the point of view taken since the main losers were industrial workers in the developed world, as Donald Trump has done a good job highlighting; though the original warnings on this issue were made by Sir James Goldsmith in his book The Trap published back in 1994. But from an Asian and emerging markets perspective, globalization has been a massive positive.

World Real GDP Growth and Trade Growth

Note: IMF forecast for 2019. Source: IMF – World Economic Outlook

If globalization has probably peaked, or best case gone on hold, the other three drivers of the deflationary trend are still, for now, intact. They are debt, technology and demographics.

That high debt levels are deflationary is now well understood, and this is the main reason why US$13.2 trillion of bonds are still trading with negative yields, though down from a peak of US$17 trillion reached in late August. The reason why high debt levels are deflationary is, of course, that they create the risk of debt deflation and creditor defaults.

Global Negative Yielding Bonds

Source: Bloomberg

Technology is also a driver of deflationary pressures and, in this case, it has been a major positive. The onset of information technology has clearly boosted productivity, just as it has led to falling prices, with “data” in the digitalization era now replacing “energy” as the key driver of developed economies. But in this case it has been tricky for conventional-thinking central bankers to fit this benign factor into their models which assume that falling prices and “deflation” are always a bad thing.

Then there is demographics. In this respect, the world is aging fast. Meanwhile, as in so many other things, Japan has been the lead indicator of the aging demographic trend. The negative aspect of aging demographics is obvious. But it is also the case that Japan’s experience in the nearly three decades since the Bubble Economy burst looks much less serious if it is measured in terms of GDP per-working-age population, as opposed to GDP.  Thus, nominal GDP per working-age population has risen by 20% since 4Q97, compared with only a 3.9% rise in nominal GDP over the same period (see following chart).

This raises the issue of whether the extreme monetary policy easing implemented in Japan in recent years is really appropriate given the demographic realities. Such a skeptical point of view was argued by former BoJ Governor Masaaki Shirakawa before he was replaced by Haruhiko Kuroda in 2013. I agree with Shirakawa, which is why it is no surprise that Kuroda has since then never been able to meet his 2% inflation target.

Japan Nominal GDP Trend and Nominal GDP per Working-age Population

Source: Japan Cabinet Office, CEIC Data

Central Banks Becoming a Tool for Political Leaders

The trend towards politicization of central banks has been highlighted by The Donald’s increasingly outspoken criticism of the Fed via his frequent tweets.

The replacement of Shirakawa by Kuroda, as part of the launch of so-called Abenomics, was perhaps the first example of the overt politicization of G7 central banks, which is fast becoming the dominant trend. In this respect, Japan has again been a lead indictor.

In America, of course, the trend has been highlighted by The Donald’s increasingly outspoken criticism of the Fed via his frequent tweets. Still, while the Powell-led Fed has tried to remain detached from such criticism the practical reality is, as previously argued here (More tariffs mean more monetary easing, Aug. 28, 2019), that the Fed’s dovishness since the “Powell pivot” has enabled the Trump administration’s hardline stance on trade. This is because the Fed has taken into account the macro uncertainty represented by the Trump administration’s threat of higher tariffs as one reason to cut rates.

Meanwhile the topic of central bank independence came into prominence recently after former New York Fed president William Dudley published an op-ed in Bloomberg Opinion in late August arguing that the Fed should stop enabling the Trump’s protectionist agenda on trade (see Bloomberg article: “The Fed shouldn’t enable Donald Trump”, Aug. 27, 2019).

Dudley also argued that the Fed should not be in the business of helping Trump be re-elected in the sense that, if the Fed was not easing, the American stock market would likely be much more exercised by the trade war and the threat of tariff escalation. It should be remembered that Trump still threatens to impose 15% tariffs on the remaining US$160 billion of Chinese imports in December if no trade deal is forthcoming. 

The Dudley article created a furor at the time, with much criticism that the former New York Fed chairman should not be encouraging the Fed to become involved in the political process. I regard this noise as a storm in a tea cup. The reality is that Dudley has done the world a service. By raising the issue, he has highlighted that the Fed made a value judgment as a result of its decision to enable Trump’s protectionist agenda, as reflected in the “Powell pivot” and its subsequent dovish statements and actions this year. True, the decision to start cutting rates and end quantitative tightening can be defended because of the market signal sent by the dramatic flattening of the yield curve seen in the first eight months of the year driven by declining long-term bond yields (see following chart).

U.S. 10-year – 2-year Treasury Bond Yield Spread

Source: Bloomberg

The conclusion remains that it is unlikely the Fed would have cut rates by 50bp already if there was no trade war with China. What about that trade war itself? The base case remains that Trump will not want to proceed with the threatened tariffs in December since they will be levied mainly on consumer products, thereby posing a real threat to the American economy just 11 months before the presidential election. After all, the consumer is about the only source of strength for the American economy at present aside, of course, from government spending.

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