The financial markets are governed by a few major principles: economic environment is key and affects asset prices. The trade-off between growth and inflation has to be at its peak to ensure optimal allocation of resources in the real world and to maximise the assets’ valuation in the financial world.
So if we had to explain the current state of affairs to a layman, we would say: “right now growth is present, the problem is inflation, and if inflation climbs to 2.5% it will be bad news for the markets.”
Of course, a layman would think a statement like that is stupid since a general price rise of 2.5% hardly seems to be a problem. And yet.
How can we explain this type of situation? Well, the answer is clear for professionals in the finance industry. The monetary authorities set certain goals: maximise employment and maintain price stability. And the yardstick for price stability was set at 2%/year, meaning that the price of an average basket of consumer goods and services increases at a rate of 2% per year.
The 2008 crisis torpedoed these ambitions and put enormous pressure on the monetary and fiscal authorities alike to restore adequate economic conditions. Unconventional policies were conducted in a bid to close the huge gap between economic goals and economic reality.
Economic conditions have now normalised, but economic policies have not. They are still highly accommodative. Meanwhile, investors have zeroed in on above-target inflation as a major risk, sparking restriction in monetary policies. Which is why an inflation rate of 2.5% or higher would be a very bad sign for the financial markets.
We would like to discuss these points, because in our view, this way of seeing things is no longer valid. The measurement of inflation and the role it plays are too vague to assign any real importance to the 2% annual growth target for the price of the average CPI basket.
Economic theory teaches us that low, stable inflation is better than strong and/or volatile inflation because it optimises the consumption and investment behaviours of private-sector economic agents. And since we're talking about human behaviour, economists point out that inflation perceptions are every bit, if not more, important than the actual level of inflation because a change of perception can lead to a change in agents’ behaviour. This is why the monetary authorities examine very different inflation indicators in assessing the measurement of inflation.
The truth is it's all very hit-and-miss.
- There is no proof that inflation of 1% or 3% is bad for the real economy.
- The average reference points (average basket, average consumer) make no sense.
- There is no proof that economic agents are influenced by price dynamics.
These are the points we would like to stress. It is extraordinary to see the central banks so obsessed with this 2% target (and having sold the idea to investors) given how shaky their assumptions are.
=> Is there less growth when inflation veers away from 2%? No.
=> Is perceived inflation as important as actual inflation? Hard to say. The relationship between real inflation and consumer behaviour is unclear, so testing the relationship between perceived inflation and consumer behaviour is too complex. We would also point out that the correlation between real and perceived inflation is highly unstable.
Central bank economists have dissected inflation, calculating different price indices:
- by household profile (based on income) because their profiles vary widely, which is one of the biggest sticking points with the average consumer approach.
- or by frequency of purchase (whereas the standard index is weighted by spending amount).
The left-hand chart presented below is taken from the latest price report published by South Africa's National Statistics Office. It shows different inflation rates. Low-income households saw an annual price rise of 1.3% in March, compared with 4.4% for households in the Cape region. So which inflation rate should the central bank take into consideration?
Another major criticism of the CPI is the “quality adjustment.” The aim of this adjustment is to correct the prices of goods and services which have improved (cars now equipped with GPS, HD TVs, etc.). The underlying assumption is that consumers are aware of technological advancements to such an extent that, when they buy a new ping pong table, they adjust the price increase to account for the higher quality of the table surface. Well, sure, we all do that!
Another better-known example is the price of smartphones. The right-hand chart compares the annual variation in the “Telephone Equipment” component of the European CPI (in orange) with the change in the average selling price of mobile phones (in blue). The difference is huge, but most economists find that normal based on the quality adjustment and consumer super-powers.
What does the consumer think? And more importantly, what can we take away from all this?
We can draw multiple conclusions, in fact. While central banks may be obsessed by price stability (defined by an inflation rate of 2%), the fact of the matter is:
- It has not been demonstrated that a deviation from this target (either below or above) creates weaker or less stable growth (it's also worth noting that the last financial crisis erupted after a period of price stability as defined by the central banks).
- It has not been demonstrated that consumers adjust their inclination to buy according to real inflation.
- There are several inflation rates because there is no such thing as the average household.
- The perception of price increases by consumers can be very different from the inflation rate actually measured by the monetary authorities. And, for that matter, it has not been demonstrated that consumers adjust their inclination to buy according to perceived inflation.
- The inflation rate is understated because of the “quality adjustment” methodology. Or put differently, more innovation (i.e. enhanced products) means lower inflation rate.
What we're getting at is: the range of inflation estimates is very broad and its role/impact in the developed world is very vague. So why organise monetary policy and, “by contagion”, the financial markets around a target as specific as 2%?
Price stability in the developed world is a given. That's not the issue. The issue is growth. The real question is whether monetary policy should be based on real economic variables (employment & production) as opposed to price variables. At this point, it's just getting silly:
- Japanese yields have been under 1% for 23 years now because inflation is considered too low. Is Japanese deflation really a monetary problem?
- European yields are at an all-time low, while economic growth is returning to 1998/2000 and 2006/2007 levels - two previous cycle peaks.
The fact that central bankers are unable to normalise yields because of highly imperfect inflation measurements and very unstable assumptions on the role of inflation could have potentially adverse consequences. These consequences are difficult to imagine simply because there has never been a similar situation in all of history. It is now clear, however, that during the next recession yields will have to fall much further (-4% or -5%?) to generate a counter-shock. Is that efficient, in the economic sense of the term?
The comments and opinions expressed in this article are those of the authors and not necessarily those of Candriam.