Introducing the “reverse Volcker moment”

Is the US experiencing a “reverse Volcker moment” in which low and stable inflation gets subordinated to other economic objectives? Markets seems to hint this and an increasing number of central banks in the rest of the world appear concerned about it.

It is now over 30 years since Paul Volcker came into the US Federal Reserve and unambiguously put crushing inflation at the top of his agenda. What followed was a period of price stability – by the middle of the last decade, many people had bought into the concept of “the great moderation” and the “Goldilocks” economy (not too hot, not too cold).

The 2008 global financial crisis did little to alter the perception that inflation had been conquered. Indeed, the price challenge at that time was not too much high inflation but rather, a real threat of a disorderly decline in the general price level.

This may now be in the process of changing. There is a growing sense among some that today’s Fed would not only tolerate higher inflation but may also be wishing it – if not already targeting it.

The immediate catalyst is, of course, the central bank’s recent actions and statements. Four merit particular mention: the extension to mid-2015 of the forward guidance language on rock-bottom interest rates; the further ballooning of the Fed’s balance sheets through the commitment to open-ended purchases of securities; clear signals that such an unprecedented expansionary monetary policy stance will continue well into the economic recovery; and, related to all this, a subtle evolution of the official inflation narrative;

There certainly are legitimate and sensible reasons for a change in the Fed’s ranking of the components of its dual mandate: by placing employment well above inflation. Joblessness is stubbornly high, and has been so for far too long. As this situation persists, and it hits more disproportionately the young and the long-term unemployed (as is the case today), the greater the risk that this horrid crisis will get deeply embedded in the structure of the economy.

It also helps that many feel it is virtually impossible for the US to experience high inflation in the context of such large spare capacity.

America’s debt is another reason. It is not easy to safely deleverage a highly-indebted economy – and I stress safely – when growth is so sluggish. Financial repression, the technical term for the manner in which the Fed suppresses interest rates so that creditors de facto subsidise debtors, can help. But it is not enough. With the political process hindering meaningful reforms and refusing to sensibly allocating principal losses, the temptation to resort to “somewhat higher” inflation is unquestionably there.

An important and consequential question is how the system would respond, nationally and globally.

Already, financial markets are starting to notice. Just witness the 25 basis point surge in break evens in the hours following the Fed’s QE3 announcement on Thursday last week, representing a “5-sigma event” for this market-measure of inflationary expectations.

Then there is the reaction of other countries. An increasing number of central banks, be it Brazil’s recent market interventions or Wednesday’s surprise announcement of additional Japanese balance sheet expansion, are being forced into a more expansionary monetary policies. Their intention is clear. They wish to counter the collateral damage emanating from the fed’s unconventional policies – from potentially destabilising surges in capital inflows to currency appreciation that erodes competitiveness. These may be leading indicators of a global economy that is slowly starting to sense that, as my colleague Bill Gross recently put it, we may be entering an age of higher inflation. Having so decisively been eradicated from the collective psyche of Americans more generally, it will take time for society as a whole to adjust to the real possibility of both higher and less stable inflation over the medium term.

The average American does not worry much today about inflation judging from the allocation of their investment and retirement assets, price setting, and how wage settlements are negotiated. This could well be on the verge of evolving if the Fed is indeed in the midst of engineering a reverse Volcker moment.