The deflation bogeyman is back

…for some, it may be that he never went away. To be fair to central bankers, following the Lost Decade(s) of Japan, the deflationary demon has been their ultimate fright night. They all know the answer to fighting too much inflation, but too little and the jury is still out. The financial crisis provided their ultimate beta test, what with it being the end of civilisation / brink of anarchy and all. With the velocity of money at zero and banks frozen and failing, they had to pull some kind of deflation-zapping weapon out of the bank.

This mindset continued as countries’ debt spiralled out of control, and then as oil prices collapsed. A punch of QE here, a smack of negative interest rates there. It was a deflation-busting free for all.

This insight into the central banker mindset is relevant once again, what with higher growth failing to translate into higher inflation. Or more specifically, higher wage inflation. Let’s not bore on again about flat Phillips Curves. We are in the midst of a decade long technological revolution, it should be no surprise that worker productivity and the wages they are paid have been affected by the rise of the internet. Looking at kittens, Tinder dates gone faecally wrong, and an Irish family trying to catch a bat trapped in their kitchen all have their impact. (OK and AI, big data, driverless cars, Uber, Deliveroo, Amazon and the rest). ((Definitely watch the bat video though)).

The point is, there’s growth around, but not in wages.

So up pops a couple of Fed speakers yesterday:

  • Kashkari: ‘We at the Fed might be making one of two fundamental mistakes: Number one, we might be overestimating how tight the labor market is. And number two, we at the Fed may have allowed inflation expectations to drift lower. Both of those, if those really happened, could explain the low wage growth, the low inflation, and the seemingly tight labor market’
  • Brainard: ‘We should be cautious about tightening policy further until we are confident inflation is on track to achieve our target,’ [If inflation continues to fall short of the central bank’s 2 percent target] ‘it would be prudent to raise the federal funds rate more gradually.’

Yes, that deflationary demon is back. What if the Fed rate hikes to date have summonsed him, in a kind of FOMC ouija board way? Kashkari has been so worried that he has been formally excusing himself from the séance by dissenting to the official rate hike decisions since March. He may also, what with his political past , be gearing up for the nod from President Trump after Yellen’s term ends. Brainard is more credible, although also a notable dove. The US 10 year decided to hit fresh lows for the year anyway, at just 2.07%. There’s a certain flight to safety taking place, what with North Korea and the news that Irma is now the most powerful hurricane ever recorded in the Atlantic. But central bankers remain preoccupied with their inability to generate inflation.

We will see just how much that’s really worrying them with the Bank of Canada meeting today and the ECB tomorrow.

In Canada, a 25bp hike is priced at 50%, and if they don’t go today the market pricing expects they will next time. And then to pause, with this characterised as taking back the two “insurance” 25bp cuts that a panicked Poloz executed in 2015 in response to the oil price fall. Their January 2015 cut came as a surprise, on the day before the ECB surprised with their QE package, at a time when everyone was falling over themselves to cut. The question now is whether everyone falls over themselves to hike but in the most dovish way possible? Or, given the strong global growth data we looked at yesterday, can they have the courage to hike properly?

Ah but what of inflation! It’s so pesky! The inflation rate in Canada is now at very similar levels to where it was when they got on their 2015 cutting bandwagon:

But don’t worry. As we remarked about the BOC’s cut in Jan 2015, ‘when a central bank starts talking about excess supply of cattle, you know the jig is up. They want to cut rates and they’ve found their argument’.

In other words, these guys can make any argument they want. That’s why understanding their mindset is so important. FWIW, Blondemoney believes the Canadian economy is doing well enough for Poloz to be bold today. If he isn’t then it’s a sign that central bankers are having nightmares again. Which means another turbocharge for risky assets, as cheap money plus global growth equals Fun Times.

Will Draghi be spooked by currency strength tomorrow? Or is he a man who always sleeps soundly, no baseball bat under the bed? We will soon find out.

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