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Last year, Tony Yates — senior advisor to Fathom — argued there are strong theoretical arguments for central banks raising inflation targets above 2%. In his words:
“the benefits of such a decisive move would far outweigh those of tinkering around the edges — for example by targeting a rate of 2% on average over time.”
Last week, at the Jackson Hole Symposium, the Fed announced a 2% average inflation targeting regime. In theory, the benefit of this approach comes from the commitment to keep rates low and policy loose for a long time following a crisis. Under such a regime, expected inflation is higher and, other things equal, real rates are lower, thus stimulating the economy. However, in reality, the benefits of such a policy are quickly eroded if individuals are not rational and do not see lower rates as a harbinger of higher inflation. Likewise, in a world in which a boom yields a persistent inflation overshoot, policymakers would be committing to driving inflation back below the long-term target (presumably through inducing a recession) where before the central bank needed only to have driven inflation back to 2%. Do policymakers really have an appetite to pursue such a policy?
In the near term, US inflation appears to have turned a corner with April, the trough in the twelve-month growth rate, now firmly behind us. Lower rates in the second quarter were primarily driven by falling oil prices (due to short-term excess supply). Since then, the WTI price has recovered to around $40 per barrel suggesting that oil’s peak deflationary impact has now passed. Indeed, even in the event of a widespread second wave of the virus, it seems unlikely that we will see a repeat of the collapse in oil prices earlier this year. As a result, the odds that base effects cause a brief inflationary spike in the second quarter of next year are high.
Either way, investors seem to be increasingly gearing up for higher inflation with the yield curve steepening and inflation swaps levels not seen since the start of the year. Fathom’s view had always been that the fall in market-based inflation expectations was overly dramatic.
We questioned investors’ increasingly bearish outlook for inflation as far back as the 19 March when we argued that COVID-19 had had an impact on both the demand and supply sides of the economy and that it was far from certain that the net impact on inflation would be negative. Indeed, the combination of loose monetary policy, fiscal stimulus and a rapid expansion in the money supply mean that the upside risks to the inflation outlook are increasing.
The Fed’s inflation target was not the only topic discussed at the symposium — the infamous ‘r-g’ gap was also on the agenda. Though simple in formulation, this accounting identity is the key to understanding government debt dynamics; the higher the real growth rate is relative to the real effective interest rate, the looser a government can be with its finances. This gap has, broadly speaking, been negative since the Global Financial Crisis, allowing many governments to sustainably run budget deficits.
As Fathom highlighted back in 2017, the gap tends to close over time, if not completely then at least partly. And, the gap can close from either side — on the g side, medium-term growth prospects appear grim due to weak productivity growth and a declining working-age population while on the r side, rising inflation could lead to higher rates. Speaking at last week’s symposium, the OECD’s chief economist expressed her concern that current fiscal policies are only sustainable provided r remains low and that this could lead to pressure on policymakers to keep it that way.
Of course, both the recovery in economic output and the path of inflation remain contingent on the path of the disease. And while new cases in the US appear to be falling, the same is not true everywhere; last Friday, India announced a record 77,000 new cases. Likewise, several European countries are grappling with new outbreaks of the virus. This raises the prospect that the economic recovery could become increasingly heterogeneous, despite the downturn being largely synchronised.
We now have enough GDP data to assess the macroeconomic impact of the virus in the first half of the year. Of the 58 economies for which we now have GDP data for the second quarter, only China has recovered its pre-crisis level of output, according to official figures. Uganda, meanwhile, has reported two consecutive quarters of economic expansion. At the other end of the scale, eight economies have reported that output has fallen by at least 20%. One of those — Macau, which is heavily reliant on the tourism and gambling industries — has seen a cumulative contraction of 64% since the start of the year.
There appears to be very little evidence of a trade-off between health outcomes and economic outcomes in the first half of the year. On the whole, countries that have handled the health crisis well — in particular South Korea, Taiwan, and Vietnam — have achieved better economic outcomes. Sweden, the European outlier in its approach towards lockdowns, has experienced similar economic outcomes to the likes of Denmark, Finland and Norway but suffered from a far greater health crisis.
The key to the success appears to be accurately tracking the spread of the disease. According to the University of Oxford’s COVID-19 government response tracker, Taiwan, South Korea and Vietnam all began comprehensive tracing regimes early. Without these measures, it seems that lockdowns (which do entail a heavy economic cost) were the only way to prevent a rapid spread of the disease. In contrast to the Asian success stories, the Oxford researchers judge that the UK did not manage this until June and that the US still has not achieved it.
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