Asia/Pacific: Enough Tightening?
Andy Xie (Hong Kong)
Central Bankers as Santa Claus
Global central banking has gone through an amazing transformation in the past decade. Twenty years ago, after the trauma of stagflation in the 1970s, Paul Volker’s disciplinarian approach made him the model central banker.
At that time, ‘taking the punch away just when the party gets going’ came as a nasty surprise. Central bankers were so unpopular that they needed constitutional protection of their independence so that they could prescribe their bitter medicine to an unwilling public, for the long-term good of the economy.
Central bankers today look suspiciously like Santa Claus. They provide more booze and nibbles when the party starts to run low. They nurse bubbles like doting grandparents. Consequently, financial markets have come to expect central banks to bail them out whenever they run into trouble.
When inflation happens, central bank pampering is supposed to stop – like doting grandparents running out of money. However, a new trick is being discovered to fill the hole. The data-dependent Fed suddenly wants us to ignore current inflation and focus on a future with no inflation.
In Asia, the Bank of Korea and the Monetary Authority of Singapore are still behaving like the disciplinarians of the past. Others are taking a leaf out of the Fed’s book. Central bankers nowadays too often sound like bullish Wall Street analysts who can explain away all investors’ worries.
Real Interest Rate Is Low, Inflation Is High and Rising
The basic reason for rising inflation is that global real policy rates are less than half of, and global inflation 50% above, average levels over the past decade. Real interest rates are not high enough to exert a headwind against inflation.
The risk of accelerating inflation is even higher, considering that central banks have pumped enormous liquidity into the global economy over the past decade. Until recently, the inflationary effect of the liquidity was held back by deflationary shocks. Instead, the money inflated asset markets, which, in turn, boosted global demand.
As the effects of these deflationary shocks are wearing off, the stock of excess money in the financial system is turning into inflation through rising commodity prices, rising wages, rising rents, etc. To hold back inflation, real interest rates therefore need to be higher than at a similar stage of the prior business cycle.
The Fed has a story for those with inflation concerns – i.e. the weakening housing market will slow the US economy, which will bring down inflation. A side story is that the base effect from high oil prices will run out. The Fed wants to focus the discussion on the technical factors of inflation rather than the fundamental factors such as real interest rate and money supply.
Global inflation is already at a ten-year high and is likely to rise further. The bottom line is that money supply is too high and real interest rates too low for price stability. If oil prices stabilize, inflationary pressure will likely shift to other areas.
Why Are Central Banks So Reluctant to Tighten?
Three unique factors in this business cycle may explain why central bankers are so reluctant to tighten. First, globalization has created positive externality in the tightening of an economy. When one economy tightens, it shifts down the global demand curve, which decreases tightening pressure on everyone else.
For example, were a large economy like the US to tighten aggressively, it would cause oil prices to decline. Inflationary pressure in Asia would then surely decline, which would allow Asian economies to tighten less and their consumption to be stronger than otherwise.
The tightening externality turns global tightening into a strategic game. Everyone is waiting for others to tighten. As a result, tightening is much slower than in a closed economy.
Second, asset markets are much bigger relative to GDP than before, which makes the effect of tightening less predictable. The ratio of property and stock market value to GDP in the global economy has risen by about 50% in the past decade. This is a consequence of past monetary stimulus to deal with deflationary shocks.
If the tightening is fast, the bubble could burst quickly, and the global economy could go straight from inflation to deflation. Hence, central banks see inflation as the lesser evil.
Third, most central banks still enjoy credibility in fighting inflation. Hence, inflation expectations are creeping up very gradually – i.e. central banks see low cost in tolerating a bit more inflation than promised.
Rising Risk of Global Hard Landing
What will cause central banks to panic is a price-wage spiral. There are signs that wages are accelerating in both developing and developed economies. However, considering inflationary pressure, wages are still relatively tame. The main reason is the fear factor over job security due to globalization.
Globalization came as a shock to job security, especially in developed economies. However, this shock is mostly over, I believe. Manufacturing outsourcing has run its course. China’s FDI flow into manufacturing peaked in 2004. Service outsourcing is much more difficult than initially thought. Dell’s trouble, for example, stems partly from service quality deterioration due to its outsourcing programme.
While the shock may be over, the fear factor is still exerting an effect on labor’s resolve to demand wage increases in an inflationary environment. The fear factor, however, may cease to work soon. When it happens, a price-wage spiral could set in.
While most central banks in the world seem on the dovish side, they are unlikely to remain so if a price-wage spiral emerges. They would have to cause a recession and high unemployment to cool wage rises. The more dovish the central banks are today, the higher the risk of this hard landing scenario.
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