The Bells Toll On Monetary Policy: A Shift in Policy
Prior to 2020, global GDP remained relatively muted, fluctuating between 2.52% in 2012 to 3.28% in 2017, back down to 2.33% in 2019 based on data from the World Bank. This low level of global GDP growth created a uniformed expansionary environment by monetary authorities, as there was a need to drive GDP growth higher after the Great Financial Crisis (GFC) of 2008. Global inflation was also range bound, being measured at 3.45% in 2012 to 1.43% in 2015, back to 2.18% in 2019 based on World Bank data. Given these conditions, common tools utilized by such monetary figures was a reduction in the policy rates to drive higher investments by corporations, with fiscal authorities reducing their borrowing to lower the “crowding-out” effect. The goal in mind was to drive inflation higher, which in-turn would have resulted in higher levels of GDP output, which would have increased key livelihood measures such as GDP per capita.
With 2020 being an unprecedented year with regards to a pandemic, monetary authorities pushed the boundaries of their monetary tools with the extraordinary policies also never seen before in our history. These policies saw interest rates approach the zero bound, making real rates even negative (real rates is nominal rates less inflation). The implementation of extraordinary levels of asset purchase programs never seen before were also utilized, also known as Quantitative Easing (QE), as means of introducing liquidity into the markets. It’s been well documented to date that the level of impact caused by this pandemic required these extraordinary measures and provided the necessary support to the global economy while slack increased due to operating below its true capacity.
However, with the introduction of vaccination programs globally (albeit skewed to developed nations), leading to the reopening of some economies and interconnected industries (such as travel), there has been concerns of potential ‘overheating’ of economies if the posture of policies remains the same while the economy is refinding its footing. We have observed gestures by monetary figures amongst developed and emerging markets of subtle signals that a tidal change is monetary policy from expansionary to tightening is approaching. This comes after the latest release of Federal Reserve July meeting minutes this week, while even our local Bank of Jamaica (BOJ) Monetary Policy Committee meetings signaling the same. This change in posture has all around implications at the economic level, the business level and the asset class level.
The direct implication of a tightening of monetary policy to the overall economy is higher interest rates and lower levels of QE. This is done to curtail inflation, as inflation at certain levels is corrosive. How so ? Well, when examining some characteristics of money such 1) Storage of Value and 2) Unit of Measure, inflation has a negative correlation with these characteristics. As an example, if a unit of money is used to purchase a fixed basket of goods and services, inflation would represent that increase in the fixed basket. Relative to the amount of money, which remains fixed, once we adjust for inflation, both the value of money and the unitary amount of what it can purchase are both reduced. Hence you require more money to purchase the same basket of goods and services. Cases of this can be seen on an extreme end in countries such as Zimbabwe in 2008, that required $10 million Zimbabwe dollars for just a sandwich. What inflation does, at its core, is it erodes the consumption capacity of individuals.
The truth is, inflation can take multiple forms, but for the purpose of this article (and based on the type of inflation we are seeing currently globally), we will be focusing on Cost-Push Inflation. This inflation occurs when demand outstrips supply, as is the current case with regards global trade disruptions caused by COVID-19. When the economy was closed, many business ceased operations as there was little to no demand to consume the produced goods or services. However, with the reopening underway, demand has been onboarded at a high velocity due to the high levels of fiscal support provided by governments (global savings as a % of GDP stands at 26.67% as at the end of 2020), thus increasing demand while supply chains struggle to be re-established. The linkages in global trade between trading partners, reopening of ports with COVID-19 protection measures in place, retrofitting warehouses to protect both staff and consumers, and the list goes on. The differences in how operations occur now prior to Covid all feed into the laggard nature of the supply chain, thus requiring those who needs it the most to pay more for it (hence Cost-Push Inflation).
While the argument within the economic community if this level of inflation will be transitory in nature (temporary) is still ongoing, we have observed hard evidence that there has been a pivot in policies. Economies such as Brazil and Hungary have begun raising interest rates to combat inflation. The FED has begun contemplating reducing their level of QE, while the Bank of Jamaica has signaled the possibility of raising rates. Next week we will examine the potential implications of this change in posture to businesses and subsequentially asset classes.
Written by Haughton Richards, FRM, FMVA, Senior Investment Strategist
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