Evening Must-Read: Gavyn Davies: Central Banks Frozen by Uncertainty and Supply-Side Pessimism
Gavyn Davies: A dose of humility from the central banks: “The leading central banks in the developed economies have, of course, been the main actors underpinning the global bull market in risk assets since 2009. For long periods their stance has been unequivocally dovish as they have deliberately tried to strengthen an anaemic global economic recovery by boosting asset prices….
It is now quite difficult to generalise about what central bankers think. However, a few of the necessary pieces of the jigsaw puzzle slotted into place in the past week…. Ms Yellen is that she has declared herself to be the agent of continuity not the harbinger of a significant regime shift at the Fed…. A regime shift designed to shock the US economy back towards the pre-2008 trend line…. Why has she not done this?… She does not seem convinced that a further large dose of asset purchases would be successful anyway, in the context of a large drop in both productivity growth and the labour participation rate. Economists at the Fed, like the Congressional Budget Office, have been moving towards supply-side pessimism, implying that more of the post-2008 output losses are now thought to be permanent. Ms Yellen said on Tuesday that she was not sure how much of the decline in the labour participation rate could be reversed. Her uncertainty about this scarcely supports dramatic policy action either way.
There are also signs of supply-side pessimism at other central banks…. The BoE’s latest Inflation Report has reduced productivity growth projections, and says that the amount of spare capacity in the economy is only 1-1.5 per cent of GDP, despite the fact that the level of GDP is still below the 2008 peak…. The ECB also has a pessimistic view of the supply side, which explains why it does not see any urgent need for a big monetary policy change as inflation drops towards zero….
If the central banks are becoming more pessimistic about the supply side, this could spell danger for markets that have perhaps already priced in a strong medium-term recovery in GDP towards previous trends. Without the prospect of this GDP recovery, the high share of profits in current GDP could start to pose problems, especially if the central banks are expected to raise short rates within a year or two. Regardless of the path for short rates, asset purchases are petering out everywhere except in Japan, and Chinese liquidity withdrawal is adversely affecting Asian monetary conditions.
Yet the prospect of genuinely hostile central banks for markets still seems some way off. Above all else, policy committees seem highly uncertain about the right path for interest rates now that asset purchases are ending. But there is an emerging degree of consensus that global inflation, notably wage inflation, remains inconsistent with their mandates…. At present, they seem to be leaning towards humility about what they know and can achieve. In an environment of unavoidable doubts about the labour market constraints that they are facing, it seems that they will let wage inflation increasingly act as the judge and jury for the stance of policy. Their latest refrain is that inflation will return to target, but only over a prolonged period, and that wage inflation will be the crucial signal.