Ignacio de la Torre. Professor. IE Business School
29 April 2016
Watch out. The risks in monetary policy are growing, which could threaten the valuation of a large number of assets.
The world we have built since the crisis is based on two important premises of monetary policy: a) low and lasting rates of short-term interest and b) massive injections of liquidity made by central banks which cause drops in long-term interest rates. Both factors are in turn based on a key hypothesis: there is no inflation, nor is any expected. Hence, central banks have a big margin whereby they can maintain an ultra-expansive monetary policy, and when the time comes, they will have a long period of time over which to normalize it. These premises “justify” that the ten-year US bond, for example, is at its highest level in the last 210 years, that Spain is funding itself more cheaply than the US (somewhat paradoxical given that the US has never gone bankrupt since it became independent, and Spain has gone bankrupt three times since 1800) or that the German bond has the highest price in its history.
Nevertheless, as the vice chair of the FED, the great Stanley Fisher, recently pointed out, inflation could now be picking up pace, thereby threatening the axiom on which the market relies in order to fix such abnormal price levels.
Consider the following points:
First, the central banks, when it comes to fixing monetary policy, always base their decisions on underlying inflation rather than general inflation, in order to protect against the volatility caused by wildly fluctuating oil prices. Thus, inflation in the US currently stands at 2.3% rather than at its 2% objective, and at 1.7% when calculating the level of PCE (2.1% if the latest monthly data is used to calculate an annual figure). They are the highest levels seen in a long time.
Second, inflation, explained as a phenomenon resulting from variations in production costs, is closely linked to the evolution of salaries. The reason for this is that approximately two thirds of a company’s total costs are labor costs. When unemployment is near natural levels, the negotiating power of employees with their employers strengthens exponentially. That is why countries with very low levels of unemployment tend to see much higher wage rises than countries with high levels of unemployment. Hence central banks are very focused on the evolution of unemployment when it comes to applying monetary policy, given that low unemployment can result in high wages, and high wages can lead to higher rates of inflation, as companies try to defend their margins by raising product prices depending on how much their costs go up. In the US wages have already gone up by 2.3%, and labor unit costs (net of increases in productivity) by 2.1%, figures which tally with that of underlying inflation. The number of job openings is at its highest in the last 15 years, which means there is a lack of workers, which in turn translates into higher labor costs and an expectation that wages will continue to climb, driving inflation.
Third, inflation, namely the balance or imbalance between supply and demand in a service economy, (an economy functioning at full capacity tends to raise prices more quickly) can also be understood as the differential between the real level of unemployment and a natural level of unemployment. For example, if a law firm is operating at full capacity, and finds it difficult to find more lawyers in the labor market, each increase in orders received by the firm will tend to charge increasingly higher fees. This is the consequence of increasing demand that cannot be met by increasing supply, which tends to push prices higher. The US is now operating at full capacity, which explains the progressive increase in prices.
Fourth, inflation, as a monetary phenomenon, is already rising. Credit is circulating strongly in the US (increases of 7%), which can be explained by the fact that today the FED is maintaining a balance that is three times as high as that it has historically maintained. Although a major part of this money is not in circulation (it is accumulating in reserves on the part of banks), quite simply the small fraction that is circulating is making for an increase in credit, which in turn drives inflation. If this trend continues, prices will rise even more.
Fifth, there is a considerably dangerous trend in terms of financial stability which cannot be ignored – asset inflation. Today we are rightly afraid of asset bubbles (the most obvious is that pertaining to the ten-year bond), and, as we learnt during the crisis, ignoring asset inflation when it comes to establishing monetary policy is a terrible mistake.
The evidence supporting the depth of the problem described here is key. The US now has the highest levels of underlying inflation since 2012. The evolution of the European economy is lagging behind that of the US, but it is showing similar trends – drops in unemployment, progressive rises in wages, and acceleration in circulating capital, and the result is a rise in underlying inflation. In the US the “median,” (or rather nine votes) of the committee that establishes the FED’s monetary policy thinks there should be two further rises in interest rates this year, but 8 members believe that there should be three or four rises. Hence the swords are drawn and raised, and in any case, there will be continuous rises until monetary policy is normalized with rates of around 3.25%.
The inexorable consequence is a formidable one: the risks in monetary policy are growing, which could threaten the valuation of a large number of assets.