What is all this talk about raising the target rate of inflation about? And what could it potentially mean for investors?
The perceived target rate of inflation is 2%, with a gray area of up to 3%, or at the very least that is what modern conventional wisdom seems to suggest. Anything above that will surely cause the Federal Reserve to interject with an interest rate hike to get inflation and inflation expectations under control. So what is with all this chatter concerning possibly raising the target rate of inflation (even if only for a finite amount of time)? There might be nothing to it, but for a moment or two, it is probably worth considering the implications of such a change–in the event it actually occurs.
Where is this chatter coming from? I am not exactly sure what prompted all the discussion around this topic chronologically. It might have something to do with Janet Yellen’s nomination to the Vice Chair of the Federal Reserve, recent IMF papers, Barclays’ reports, or perhaps a recent paper that is forthcoming out of the Federal Reserve Bank of San Francisco arguing that perhaps increasing the target rate of inflation could yield positive effects for the economy during this recovery period. Individually, these papers and discussion, taken one by one, could easily been brushed off as unrealistic. However, in these papers and discussions taken in aggregate, definitely begs the question about whether the FOMC is actually considering raising its target inflation rate (even if only for a limited duration).
Is this worth considering? The various Federal Reserve banks and the IMF do a lot of theoretical research and writing about policy for the sake of the discussion and future research ideas. Barclays on the other hand puts out research to serve investment clients. Of course, this is blatant speculation on my part, but I have to wonder where Barclays gets research ideas to devote manpower to studying. I have a hard time believing Barclays devotes much attention to ideas they think are irrelevant which is to suggest that spending a little time thinking about the implications of raising inflation targets is a worth while venture.
What are the implications of moderately higher inflation for a few years?
According to a recent report from the IMF authored by Blanchard, Dell’Ariccia and Mauro, inflation targets should be higher.
In the IMF paper, Blanchard throws up the following arguments for consideration…
“Achieving low inflation through central bank independence has been a historic
accomplishment, especially in several emerging markets. Thus, answering these questions implies carefully revisiting the list of benefits and costs of inflation. The inflation tax is clearly distortionary, but so are the other, alternative, taxes. Many of the distortions from inflation come from a tax system that is not inflation neutral, for example, from nominal tax brackets or from the deductibility of nominal interest payments. These could be corrected, allowing for a higher optimal inflation rate. If higher inflation is associated with higher inflation volatility, indexed bonds can protect investors from inflation risk. Other distortions, such as the lower holdings of real money balances and a greater dispersion of relative prices, are more difficult to correct (the empirical evidence is, however, that their effects on output are difficult to discern, so long as inflation remains in the single digits). Perhaps more important is the risk that higher inflation rates may induce changes in the structure of the economy (such as the widespread use of wage indexation) that magnify inflation shocks and reduce the effectiveness of policy action. But the question remains whether these costs are outweighed by the potential benefits in terms of avoiding the zero interest rate bound.”
Like a lot of economics professors, typically stopping short of full out swinging recommendations, Blanchard goes on to argue that increasing discussions around the side of the inflation risk fence monetary policy should error on during periods of low inflation should be re-considered…
“A related question is whether, when the inflation rate becomes very low, policymakers should err on the side of a more lax monetary policy, so as to minimize the likelihood of deflation, even if this means incurring the risk of higher inflation in the event of an unexpectedly strong pickup in demand. This issue, which was on the mind of the Fed in the early 2000s, is one we must return to.”
In February he was quoted by the Financial times…
“Mr. Blanchard said the idea of raising inflation targets should not be seen as outlandish. “If we had had more margin to play with on interest rates, we would probably have had to use fiscal policy less [in the crisis],” he told the Financial Times. He recognised that higher inflation and higher interest rates in normal times would have costs, but they might be a price worth paying because they would make monetary policy more effective in crisis periods. ‘Nobody knows the cost of inflation – between 2 per cent and 4 per cent – so I think people could get used to 4 per cent and the distortions could be small,’ said Mr Blanchard.”
So what does Barclays have to say on the topic?
- "Contrary to previous periods of high unemployment and fiscal deficits, inflation remains very low, making the adjustment process harder and slower. We argue that the benefits of temporarily higher inflation for the US, UK and Japan are considerable. In this context, it is surprising that markets are not expecting inflation to rise above their targets (at least temporarily) in coming years."
- "The principal merits of inflation disappear if inflation is anticipated, so the best policy prescription today is not to increase inflation targets but rather to have above-target inflation. Central bankers know this, which gives them another reason to be ‘behind the curve’ at the start of their tightening cycle. While policymakers should worry about another asset bubble, regulation rather than tight monetary policy should tackle excessive leverage."
- "Inflation has historically been a powerful force to achieve fiscal and real adjustments. We estimate that having 5% inflation rather than 2% can dramatically accelerate the decline in unemployment, as unemployment can fall by 1.5pp in one year solely due to this higher inflation. On the fiscal front, inflation can achieve what no congress can, fast reductions in fiscal deficits. As the majority of government expenditures are not indexed to inflation and taxes rise one-to-one with inflation, we estimate that 3pp higher inflation can reduce fiscal deficits by 1pp of GDP, while eluding the political hurdles that typically prevent expenses from falling. Undeniably, as most emerging markets can testify, inflation is an undercover fiscal reform."
- "Central bankers, especially the Fed and the BoE, are likely to tolerate higher inflation in coming years. But contrary to popular belief, we believe this would be a positive development for the global economy."
It is worth considering that Barlcays argument is that the benefits of moderately above target inflation will probably only occur for a couple of years before dissipating.
How exactly does inflation interact with unemployment?
According the Barclays report…
“At today’s real wages (eg, rw0) in the figure, the gap between labor demand (how many people firms want to employ) and labor supply (how many people want to work) is positive, which gives rise to the currently high levels of unemployment.”
“Real wages do not fall fast enough to reduce unemployment because nominal wages are ‘sticky’ downwards, and with low rates of inflation the economy is left hanging in a high unemployment range for a long time. Unanticipated Inflation can reduce real wages, (eg, to rw1), and concomitantly reduce the levels of unemployment.”
“Formally, the extent of the decline in unemployment from a fall in real wages is given by the elasticity of labor supply minus the elasticity of demand. Conservative estimates of both these elasticities suggest that for every 1 percent fall in real wages achieved via a higher inflation rate, unemployment can fall by around 0.5pp. This implies that having 5% inflation in a given year can reduce unemployment by 1.5pp more than in a world with 2% inflation. In two years, unemployment can fall by 3pp only as a result of having temporarily higher inflation for two years. It is likely that after some time the benefits of having higher inflation would dissipate, as unions internalize that they need to bargain for larger increases in nominal wages and the benefit of falling real wages gets eroded. But without certainty about whether inflation will be higher in the future, and given the current high unemployment rates, it is unlikely that wage negotiations will incorporate higher inflation so rapidly. Inflation expectations have remained steady through this period and policymakers know the power of inflation surprises at this juncture. If unemployment doesn’t fall in coming years, the outlook for higher inflation expectations would probably increase as the temptations will be substantial.”
So putting all the pieces together leads me to a few thoughts…
- Above target (implicitly 2%) inflation will be tolerated more now than in the past until a solid portion of the benefits from higher inflation have been captured for at least a year and possibly two.
- If unemployment doesn’t start to come under control, inflation targets stand a solid chance of being raised (even if temporary) in order to capture benefits from short term higher inflation.
What are some possible investment implications worth considering?
- Investor reaction to higher than 2% inflation could easily cause an even bigger shift to gold–which could easily benefit gold mining companies.
- To the extent the global economy is improving and inflation (as currently measured by the CPI and PPI) is rising…by definition commodities will be rising…so base metals as well as soft commodities stand to benefit.
- Following the Barclays’ logic, equities generally stand to benefit as the benefits of modestly higher inflation are captured.
- If you are in a time period of your life that wealth preservation is far more important than growth or income…increasing your allocation to TIPS probably has some merit. In my opinion for young people this is a dumb decision unless you are fortunate enough to have a massive nest egg already.
- Avoid longer term fixed income securities. My argument is that there will be a better time for income based investors to get higher yields.
- Any other productive ideas are welcome?
Disclosure: Long Call Spreads on GDX and Long Eurodollar Futures
Disclosure: Long Call Spreads on GDX and Long Eurodollar Futures