Inflation and the anchoring bias

A combination of loose fiscal and monetary policy is likely to remain in place for a substantial period. Can we have this policy mix for an extended period when there is also potential for supply-side disruptions AND keep inflation low? We don’t know, but we suspect this theory will be tested and explore some of the opportunities this may present in inflation-linked securities.

Economists Kahneman and Tversky introduced the term ‘anchoring and adjustment’ in their seminal paper on cognitive biases back in 1974. According to the Nobel-Prize-winning economist Kahneman, people use ‘anchoring and adjustment’ to forecast the future. In simple terms they start with a reference point and then adjust to reach their estimate or forecast. What has this got to do with inflation you ask? The link may appear spurious, but I suspect anchoring and adjustment bias may be a useful way to think about inflation.

The last three decades have been - unambiguously - disinflationary: global labour supply has exploded following the ascent of China into the global trading system; central bank’s have gained independence from government; and inflation targeting has been a specular success. Markets have faith that central banks will keep inflation low. ‘Inflationistas’ have ended up with egg on their face.

The inflationistas raised the inflation alarm when central banks printed huge sums of money during the global financial crisis. Alas, inflation never arrived. Moreover, it is widely accepted that coordinated fiscal and monetary policy is not powerful enough to overcome this wave of disinflation. Japan has both the highest gross debt to GDP ratio and the largest central bank balance sheet in the developed world. Did it result it inflation? Not even a dent! Yes, inflation may rise a little bit, but if this period is the anchoring point, the adjustment will never be large enough to render inflation a concern.

Although a return to 1970’s-style stagflation is highly unlikely, we think there are three reasons why it is naive to use the ‘disinflationary period’ as the anchoring point.

Firstly, this is not QE from the global financial crisis (GFC). In the GFC expansionary monetary policy was offset by contractionary fiscal policy and a broken transmission mechanism. By its very nature it is difficult to transmit loose monetary policy to the real economy if the banking sector is broken. Today, the opposite is true; banks are very well capitalised and, as government are guaranteeing most of the loans, the risk-reward for bank lending is much more attractive.

The new money created from commercial banks (via loans) and government (via combined central bank quantitative easing and deficit spending) is starting to show up in the monetary aggregates too. Unlike the GFC, where only measures of narrow money supply picked up (such as the monetary base and narrow money) this time pretty much every money supply aggregate is accelerating in unison.

There are questions as to whether the pace of money growth can be maintained; for example, are these loans to the corporate sector purely ‘precautionary’ that will be paid off as soon as growth recovers - thus, in turn, reducing money supply? We do not yet know the answer to these questions, but we do know it would be wrong to completely dismiss this trend.

Secondly, what happens to the supply side? As it stands the coronavirus is disinflationary – demand has been hit harder than supply. Over a longer period, however, this relative balance could shift. In the short term, the surge in household savings is likely to rewind. In the medium term, it seems fiscal policy is going to play a larger part in driving aggregate demand. I think the biggest disruption could be on supply side. The coronavirus was an important reminder that some sectors are too reliant on the global supply chain. This is especially relevant for ‘strategically’ important sectors such as drugs and medical care equipment. It seems almost certain that proximity and diplomacy will force companies to challenge their reliance on low cost production.

Finally, austerity is dead. As recent as 1991 the then Chancellor Norman Lamont said, “rising unemployment and the recession have been the price we have had to pay in order to get inflation down.” Nearly three decades later the UK’s latest chancellor, Rishi Sunak said, “I want every person to know that I will never accept unemployment as an unavoidable outcome.” Does that mean higher inflation is a price worth paying to lower unemployment. I suspect a little bit more inflation is not just a price worth paying but a welcome development.

Governments around the world are going to exit this crisis crippled with debt. Only last month the IMF acknowledged that public debt is projected to reach the highest level in recorded history in relation to GDP, in both advanced and emerging market economies. The only real alternatives to reduce government debt are 1) financial repression, 2) growth, 3) austerity and 4) default.

As option 3 & 4 are politically unacceptable and option 2 is unlikely, governments are likely to turn to option 1. Option 1 relies on keeping nominal GDP – real growth and inflation - higher than interest costs. This fact will not be lost on governments. Only recently, several think tanks and economists suggested the Bank of England should switch from an inflation target to a nominal GDP target. Moreover, central banks appear less willing to lean against inflation. The federal reserve, for example, have said they will allow inflation to overshoot their inflation target to compensate for previous undershoots.

A combination of loose fiscal and monetary policy is likely to remain in place for a substantial period. If governments are not worried about distributional consequences and central banks remain sanguine about financial stability risks, there are no real losers from keeping this policy mix in place – or even pushing on the accelerator.

There is certainly no shortage of suitable beneficiaries from looser fiscal policy whether it be a pay rise for our heroic health workers or investment to tackle social inequality, poor infrastructure and climate change. This can continue for as long as governments can sell debt at ultra-low rates and/or if inflation remains low. In a world where quantitative easing is mainstream, the former is less of a worry, meaning inflation is the only real constraint.

To summarise, can we have this exceptional stimulus during a once-in-a-lifetime collapse in demand? Unquestionably, yes. Can we have this policy mix for a few years in order to aid a recovery? Probably, yes. Can we have this policy mix for an extended period when there is also potential for supply-side disruptions AND keep inflation low? We don’t know, but we suspect this theory will be tested. For that reason, and on cheap valuations, we think inflation linked bonds offer an attractive risk reward.

I will hand the baton to Stuart Edwards to discuss further.