If you put yourself in the position of a major central bank, the immediate issues to solve are low global growth and seeing off deflationary worries.
We are all aware of the unprecedented steps that central banks have taken to achieve these objectives and have also watched with growing concern the side-effects such aggressive policy action has wrought in financial markets.
As this plays out, conversation is naturally evolving into one investigating how central banks unwind their balance sheets and how interest rates normalise. It is difficult to see how this is going to be possible without a decent dose of inflation.
There is growing evidence, particularly in Europe and Japan, that central banks have little ability to further expand monetary stimulus. This puts policymakers in an awkward position as beginning interest rate normalisation too early could derail the global economic recovery and leave them with little space to backtrack. From this point of view, it is logical that central banks will err on the side of caution and wait for definitive confirmation that monetary tightening is necessary.
When the US faced high inflation in the 1980s, Paul Volker, chairman of the Federal Reserve at the time, successfully attacked the issue with aggressive policy and kept rates relatively high until inflation was well and truly under control. Similarly, in the fight against deflation, policy will not move decisively tighter without enduring signs that inflation is back. For these reasons, inflation is likely to overshoot targets in the medium term, which will be positive.
Financial doomsayers highlight several landmines that could see the global economy come unstuck. Most of these theories focus on the rapid expansion in the levels of debt in the various pockets of the economy and globally since the financial crisis. Examples include corporates using debt to buy back stock at elevated valuations or engaging in questionable M&A deals; the massive increase in Chinese private-sector debt; and unprecedented expansion in worldwide government debt.
These are potential sources of disaster but the problems are not going to surface while interest rates are so low. Rather, disaster will strike at some point in the future when the debt has to be rolled at a higher interest rate, crippling the issuer with a high interest burden with inevitable global contagion. In fact, if one looks at US government expenditure to service debt as a percentage of GDP, it would surprise most people to know this is at low levels by historical standards, despite the fact that the nominal level of debt is at a record high.
Regardless, record levels of debt do pose a major risk if we believe that interest rates will ever increase. But this risk is not going to manifest itself until then and this is still some way off as central banks are in no hurry to move against inflation with higher interest rates. This buys the world some time.
