Out of sight, out of mind

On 6 August 1979, Paul Volcker moved into his new office in the Marriner S. Eccles Building in Washington. He had just been appointed Federal Reserve chairman with a mandate to combat inflation. That year, inflation had surpassed 13% in the United States and had spread throughout the developed world.

As a follower of the Chicago School of Milton Friedman, he had a simple recipe: raise interest rates well above the level of inflation, thus making the “real” cost of debt prohibitive and breaking the upward spiral of wages and prices. That was strong medicine, raising Fed rates to 20% in March 1980, and it would ultimately trigger a deep recession in 1982-1983. It would also send inflation careening downward to about 3% by 1983. Inflation was at last under control and, more importantly, companies and households were convinced in their investment, purchasing or savings behaviour that the central bank would stay the course.

Nowadays, they are not so sure, but in the other direction. For example, the year-on-year inflation target of the European Central Bank (ECB) of close to 2.0% has not been reached, ex-food and ex-energy, since 2002. What’s worse, it has averaged just barely 1% over the past 10 years. The situation is much the same in the United States, even though it is celebrating 10 consecutive years of growth and historically low unemployment rates. This, in spite of all the warnings of the risks of uncontrolled inflation that would inevitably be triggered by non-conventional policies of all central banks after the 2008 financial crisis!

Global competition, Chinese overinvestment, globalisation of trade, automation and robotization, the ageing of the population in the developed world, and weak wage negotiating clout are all factors behind the persistent sluggishness of price dynamics[1].

So is inflation gone forever? That’s what the bond market appears to believe, given that yields are negative on almost 50% of outstanding European government bonds, despite their track-record of very high levels. Globally, €10,000 bn in outstanding government bonds destroy value on a daily basis. While the risk of an immediate and sudden surge in prices can be ruled out, entrusting all of one’s savings to spendthrift governments looks unwise.

In the midst of the earnings reporting season, companies’ resiliency and adaptability are even more noteworthy. Although only slightly fewer than 30% of European companies have released their first-quarter figures[2], and about half of them have beaten bottom-line and/or top-line forecasts. More solid momentum in economic growth and prices would have made these numbers look even better. A return to a more reasonable and standard level of inflation, would not be bad news for companies.

One thing is certain: the day that inflation awakens, equity investors will be better protected in the long term than government bond investors, who will wonder how on earth they accepted almost-zero yields for such a long time.

Olivier de Berranger

[1] “Pourquoi l’inflation reste-t-elle si faible dans le monde ?” (“Why is inflation still so low worldwide?”) Trésor-Eco, October 2017
[2] 2 JP Morgan Cazenove, 26 April 2019