Thursday, February 18, 2010

Market Impact Of Adjusting Inflation Targeting

IMF staff came out with a note last week "Rethinking Macroeconomic Policy" that has sparked the "inflating out of debt" talk again. The Keynesian school a la Krugman is trying to support the idea with a reasoning by "academic economics", that often ignores the basics of markets. On the other side of reaction spectrum the "Austrian Mish" strikes back hard, but hyperventilated Zero Hedge digs deeper.

I am listing here couple of posts more or less related to the issue above and that I was quick to find, in random order:

Why hasn't the Fed been targeting two or three percent inflation?
Conducting Monetary Policy when Interest Rates Are Near Zero: Will it Work?
Googling "Inflation targeting" and "fiscal stimulus"
“Why Bernanke’s Defense of Super Low Interest Rates Does Not Hold Up”
Chris Sims on Policy at the Zero Lower Bound

The FX strategists at BNP Paribas had a note yesterday, with their views on the market impact:

It seems that long-term trends are in the process of terminating. When in the early 80s New-Zealand adopted inflation targeting policy the economy increased its inflation neutral growth potential which allowed for a higher valuation of assets. New-Zealand became the role model for other economies and when Norway experienced its NOK crisis in 1998 it was the last G-10 economy de facto converting towards an inflation targeting policy (the ECB targets inflation and money supply and the FED targets inflation and the labour market). Inflation targeting policy has been successful with inflation not only declining in absolute levels as well as in volatility. Reduced inflation rates encourage economic agents to forecast falling interest rate volatility given that its main component would have a smaller size. As a result, investors were able to reduce cash provisions and increase leverage. Monetary velocity moved up. This process was additionally supported by Western demographics where baby boomers invested trying to create assets to draw on when retiring. This environment allowed inflation to decline, leverage and monetary velocity accelerate as risk taking could increase and securitisation grew, further pumping up capital market valuation. This was the past, but the future will look very different.

Baby boomers are set to retire and thus will reduce the pace of capital accumulation which will not bode too well for risky assets. However, the biggest challenge for capital and implicitly for currency markets will come from the inflation front. The IMF’s chief economist Olivier Blanchard claims that the 2% inflation target adopted by most G-10 central banks should be revised to a higher level with 4% probably optimal. An inflation target of 4% will allow nominal rates to rise to 6-7% providing monetary authorities sufficient ammunition for easing policies when ever required. Higher inflation rates have as well the advantage channelling wealth from asset to liability holders, from the old to the young generation and within Europe from the rich south towards the poorer south. Additional effects suggest that agents will have to assume a higher volatility of rates and yields forcing them to reduce leverage and to hold higher levels of equity relative to assets. In the long-term a conversation toward a higher inflation target will reduce monetary velocity.

But what will be the market implications. First, central banks will have to remain accommodative in order for inflation to reach a higher inflation level. This additional liquidity will seek an asset class leaving the question, which one? Since higher inflation will be the outcome of this policy we suggest that equity markets will not benefit from central bank liquidity. When inflation rises, expected earnings will be discounted with a higher (inflation) rate suggesting equity markets would not benefit. PE ratios will generally decline. Higher inflation would be hostile for any sort of fixed income related products unless it is High Yield. The flow of funds will move there were revenues can be adjusted according to inflation. Soft commodities fall into this category. We have been arguing for some time that rising income in population rich areas such like Asia and Latam will promote soft commodity prices. G-10 potentially converting to a higher inflation target will additionally promote soft commodities as an asset class. Currencies of Australia, Canada, New-Zealand and the US will benefit from this potential long-term trend.


Click on chart to enlarge, courtesy of BNP Paribas.


Well, there seem to be a lot of questions for me. First, was not the high asset prices and high debt levels compared to incomes that caused the crisis? Simply reflating to get higher asset prices do not solve the problem of incomes. US is loosing jobs because there are cheaper employees elsewhere. Secondly, food and energy inflation will squeeze out the discretionary spending in the lower income deciles anyway, so reducing the real quality of life, without making a change in the structure of incomes and consumption the effect will be short-lived? Increasing volatility will force to reduce leverage anyway. Among others also, why anyone believes that there are agents who can control that process? Rather, sovereign credit will be crucified in the name of corporate profits without any consequences?
Trying to fight secular forces?

1 comment:

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