Debt to GDP ratios have climbed to unprecedented levels across the developed world. The policy choices that fuelled that process, as well as the debt itself, are weighing on economic growth. The least damaging, most politically palatable way to deal with that debt and eventually normalise policy is through inflation. Recognising that, prominent academics and policymakers are challenging the existing inflation-targeting framework and calling for a deliberate overshoot. Central banks appear to be listening. Our concern is that it will not be enough and in time we will find ourselves in Japan’s shoes.
In the wake of the global financial crisis, central bankers were blamed for fuelling the colossal build-up of private sector credit and asset prices through excessively loose monetary policy. And yet, in spite of this valid criticism, central banks’ powers have been enhanced, with the burden of restoring the world economy to health falling to them. And unsurprisingly, the maintenance of emergency low interest rates has fostered further credit growth. Conferring progressively little economic benefit, this has seen debt to GDP ratios rise to unprecedented levels, including in the aftermath of the two World Wars, and asset prices reinflate.
Having allowed debt to climb to such levels, Mervyn King argues that central banks have found themselves at a dead end, trapped by a misplaced belief that the solution to weak demand is further monetary stimulus, as well as the economic and financial consequences of reversing course. As our regular readers will be aware, we agree that the emphasis on monetary policy to restore economic growth is wrong-headed. In fact, we believe that monetary policy, as currently framed, is not only suffering from diminishing returns but has become counterproductive, holding back growth in productive potential by preventing the gales of creative destruction.
Nevertheless, hiking interest rates now risks triggering a slowing of growth, if not another economic downturn. But as Japan’s experience demonstrates, the status quo is no better. Consumption and production cannot be brought forward from the future indefinitely. And the longer that disequilibrium continues, the more painful the eventual adjustment.
As the chart below highlights, beyond a debt to GDP threshold of around 150%, borrowing your way to prosperity no longer works. At that point, debt has exceeded its output-enhancing level and begins to weigh on economic growth. Eventually, this triggers a spate of debt defaults and the process begins again, winding its way higher until debt — whether government, corporate or household — can do no more.
With the vast majority of advanced economies at that threshold, as illustrated by an upwardly sloping line on the chart above, the solution cannot be more debt. Policymakers need to find another way out, moving away from a high debt/low yield environment to a normal debt/normal yield environment.
Although raising rates would enable a reboot of the economy, clearing out the barely profitable and increasingly unproductive firms that are able to survive only at emergency low rates of interest, the short-term pain could be colossal. Instead, soft default — brought about through a combination of inflation and financial repression — is likely to prove more palatable. This technique was employed across advanced economies in the decades following World War II, successfully — albeit slowly — eroding the real value of debt and returning economies to more sustainable debt ratios.
Although this would spell the end of monetary policy as we know it, it may already be coming to pass. Monetary authorities appear increasingly focused on supporting the prices of government securities while allowing inflation to overshoot target. Having fallen into a debt-laden trap over two decades ago, this transition — meaning the extent to which debt weighs on central bank independence — is most evident in Japan.
For example, the Bank of Japan’s yield curve target (announced last September) supposes that it will buy and sell ten-year Japanese government bonds in unlimited quantities. It has also introduced an inflation-overshooting commitment, under which it pledges to continue expanding the monetary base until the twelve-month rate of increase in the CPI (all items less fresh food) exceeds the Bank’s price stability target of 2% and stays above that rate in a stable manner.
Nearly ten years into their own debt-related quagmire, both the Bank of England and US Federal Reserve appear to be following Japan’s suit. Although the former concedes that above-target consumer price inflation will persist for the duration of its forecast horizon, peaking just below 3% in the fourth quarter, it remains reluctant to raise rates.
In its latest Inflation Report, the Bank pointed to emergent cracks in UK economic data — ironically a consequence of the pressure on consumers from rising prices — as reason for caution. With that economic softening in the first quarter dissuading Michael Saunders from voting for a hike, Kristin Forbes remained the lone dissenter and the Monetary Policy Committee (MPC) agreed to keep Bank Rate on hold at 0.25% at its meeting in May.
In the coming months, with inflation set to exceed the Bank’s forecast and growth likely to disappoint, the MPC’s apathy will be sorely tested. We see headline inflation nudging into letter-writing territory by autumn. Nevertheless, with wage growth unlikely to keep pace (a view supported by the latest labour market and inflation data), we expect Bank Rate to remain on hold.
That is what the Bank will do. What it should do is highly contested, even in Fathom.
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