US: Structurally low inflation shifting central bank focus to real rates and financial conditions

The equity market resilience this year probably owes much to an improved global growth outlook and the fact that growth may now be driven more from outside the USA may also be helping support global equity markets, broadening and reinforcing investor confidence, according to analysts at Amplifying Global FX Capital.

Key Quotes

“The USD has been relatively weak this year, helping support emerging market asset prices.”

“Global bond yields remain relatively low and have declined this year (after rising late last year).  Low global bond yields may have reinforced investors’ search for yield, boosting equities and higher yielding corporate and emerging market bonds.  Lower bond yields have in part been encouraged by ongoing ECB and BoJ ongoing commitment to negative interest rates and QE programs.”

“The Fed has been tightening, but with growth and inflation in the USA underwhelming, US yields have tended to reverse increases late last year, notwithstanding the Fed’s adherence to a gradual removal of policy accommodation.”

“Global equity markets are starting to appear fatigued.  Factors that are now weighing on equities are weaker energy prices, hurting energy shares.  Curve flattening may weigh on financial shares.  Retailing shares are struggling with the shift towards internet commerce.  Amazon’s offer for Wholefoods has increased the market’s focus on the high-tech disruption of traditional commerce.”

“The increasing use of high-tech goods for business and consumer services is a source of disinflation pressure.  Some policymakers have posited that the gig economy and self-employment trends, related to incorporating high-tech services into commerce, is contributing to low wage growth.”

“High-tech companies have been leading the rise in global equities, but perhaps this is happening at the expense of other companies’ share prices, since they are the source of disruption and weaker pricing power.”

“Low inflation outcomes may be encouraging central banks to keep monetary policy easy as they attempt to raise aggregate demand to achieve their inflation targets, typically at 2% or higher.”

“Some commentators argue that the low inflation environment is more structural and attempting to keep pushing inflation higher may result in monetary policy that is too easy, and risks building up excesses in financial markets.”

“If this is the case, central banks may shift from focusing less on their inflation targets, and more on targeting real interest rates and indicators of financial conditions.”

“This is happening to some extent in Australia, where the RBA has accepted a lower glide path back to its inflation target in deference to high house prices and excessive household debt.  The Bank of Canada recently moved to a tightening bias despite weaker inflation outcomes.  The Fed too may now be paying more attention to financial conditions, and less to its inflation target.”

“Monetary policy aimed at targeting inflation may tend to pump up asset prices to dangerous levels building in financial instability risks (by keeping real interest rates too low, below the trend rate of growth).”

“Weak pricing power, undermining operating margins, may dampen equity prices.  But they may still rise if central banks are pursuing low real rates to attempt to boost aggregate demand and raise inflation.  If central banks switch gear to managing down aggregate demand to address financial stability concerns, then asset prices might be expected to have less upside potential, including risk of a correction if they have become overbought.”