After a decade, central banks that are still not getting the inflation they crave are reverting to the tools that failed them. QE’s boost to asset prices has become counter-productive - widening disparities, stuttering demand, and stymying inflation. With central banks scared of their own shadows, the risk to markets therefore comes more from protectionism. The 1930s revealed few winners from a trade war. Stagflationary forces should mean the cost-led inflationary flame snuffs itself out. Helpfully, ultra-cheap borrowing costs are, meanwhile, offering incentives to governments to open the fiscal box.
This has modern precedent in deflationary Japan. Deflation historically has not been uncommon. Since Medieval times, the UK has spent almost as much time in deflation as inflation. Only since WWII has inflation really been considered the norm, perhaps reflecting such factors as better global trade, labour laws, inclusion of house prices, taxes, and currency falls (see chart 1). Deflation offers a number of benefits. With ‘cash as king’, savers would be rewarded over borrowers, providing funds for capex, productivity, and wage growth (the ‘Holy Grail’ for policy makers).
Yet, if we are going down the Japan route, a sizeable shift in mind-set would be required by all. For investors, the renewed attractiveness of cash may expose competing financial instruments offering inadequate premia. For growth assets, such as equities, for example, this could herald absolute falls, putting even sharper focus on relative price-shifts within asset classes.
Furthermore, consumers’ reaction would be influenced by the speed of wage-falls relative to the falls in shop and asset-prices. Stronger labour-militancy in other G7 countries and more regular pay reviews (Japan’s centre on the spring shunto) suggest greater resistance to wage cuts - especially amid populism in the US and UK, and reform-fatigue in the eurozone. So, the pressure release to margins may have to come from employment reductions and/or more flexible working. Key will be making sure the extra saving is diverted efficiently into higher capex and productivity.
It’s debtors/governments who face some of the biggest risks from deflation. The US, eurozone, and UK government’s debt-ratios are already twice Japan’s was when it entered its ‘lost decade’. Were their nominal GDP now held back by deflation (as Japan’s has been since 1995), even a modest 1%yoy rise in the debt stock would lift their respective net ratios to 105%, 80%, and 100% by 2040! This wipes out government hopes of eroding the debt via inflation.
The QE-drug would, thus, be even more difficult to kick - especially as central banks’ ‘skin in the game’ leaves them striving for the status quo. Precedent from the 1930s-1950s - when US QE ran unbroken for 14 years - and government dependence now on their central banks suggest we may be little more than half-way through our QE.
Meanwhile, the challenge may not be a general hit to living standards, but a deflationary psychology where we celebrate our pay cuts if they prove tamer than the price-fall of the holiday, car, or house we’re seeking. And, we doubt London, New York, Frankfurt, Paris, Rome etc are ready for that!