There is a danger that central banks will tighten too much. Part of the market plunge during October was a response to tougher money conditions around the world. The Federal Reserve in the US is well advanced with a programme of rate rises. At the same time, it is supervising the rundown of its portfolio of state bonds, which it bought using created money to give a stimulus in the weaken of the financial crisis.
The Chinese central bank is busily trying to clean up balance sheets amongst the shadow banks that have been advancing more credit for everything from consumer spending to buying shares. This has resulted in a slowdown in money growth. The offsetting action they took to relax controls on banks did not stop some slowdown of both money and activity. The European Central Bank is keeping rates on the floor, but is progressively cutting the amount of bonds it buys, meaning it is now tightening. By the end of 2018, it will discontinue its bond-buying programmes altogether. The Bank of England has slowed UK money growth more than the other advanced countries. It has put through two rate rises. It has cancelled special facilities to clearing banks designed to encourage more lending, and has issued tougher guidance to cut the rate of growth in car loans, some mortgages and general consumer credit.
Why are they doing this? Some say the central banks need to get closer to normal, just in case they need firepower for a future crisis. This argument is ill founded. There is no normal for these conditions that they need to return to. Were there to be a new crisis we now know they can always loosen policy more by creating more money, buying more bonds, and driving rates negative. Japan has been pursuing a policy of zero interest rates and more quantitative easing for many years after its banking crash, which was a more severe one. Surely it is better to avoid a new crisis by taking sensible actions, than to be driven to tight money before it is needed? There is no need to cause a new recession which would create other financial difficulties.
The central banks are right to watch inflation, according to their remit, and to take action if there is an incipient inflationary problem. So far, inflation in the advanced world since the 2008 western banking crash has been low, rarely above targets. So why do they think there could be a different situation next year or in 2020? They seem to be bewitched by traditional economic models that are based on a concept of capacity. As the economic recovery advances through more years, the central banks think we must be somewhere near full capacity, as unemployment drops and factories fill up. This leads them to believe we will see wages race ahead, and see goods prices rise, as buyers are told the factories cannot turn out enough product in good time for their needs. In the UK, the Bank of England and the Office of Budget Responsibility keep telling us we are near full capacity, only to discover that somehow GDP expands further without obvious inflationary stresses in either the employment or the goods market.
The reason is we now live in a much more globalised world. If a builder finds buying bricks difficult from the UK because the factories have full order books, he can buy from Holland. If someone wants a new car or more variety in food, there are plenty of imports to choose from. If an employer needs more employees, there is usually a good supply of new labour coming into the successful country from abroad, as there are still all too many people around the world with no job or lowly paid jobs who would like to improve their prospects. There are also more and more cases of outsourcing labour-intensive activities to enterprises in lower-wage countries with more unemployed. In the US, participation in the workforce is quite low, at around 60% of the working age population. We now see more people willing to come forward to do a job, as wages rise modestly and employment opportunities expand. What meaning does capacity have for any particular national economy when the global supply chains are long and flexible and when the workforce is so flexible and elastic?
This global marketplace is fiercely competitive. Cheaper on-line product is driving out the same product that is more expensive in store offerings. Deep discounters like H&M and Primark in clothing and Lidl and Aldi in food in the UK take lumps out of the market shares of traditional retailers, and help keep inflation down as they do so. They source from the best value around the world, with plenty of factories to choose from. Investors need to watch how far the authorities go in slowing things down, when there does not seem yet to be a serious inflation problem. Our base assumes they will not take it too far, but they are still worrying a bit too much about capacity constraints that do not exist at the global level. Of course, they need to avoid becoming too complacent about inflation. So far they do not appear to be behind the curve.
The above article was previously published by Charles Stanley on 6th November 2018