I have been carrying on a lot about inflation expectations here, which, as I noted earlier in the week, have been largely overlooked by the domestic economic commentariat yet would be giving the RBA the willies. I just discovered that PIMCO, the biggest fixed income manager in the world, wholeheartedly agrees in this beautifully written piece, which bears a striking resemblance to my last post on the subject (see also this PIMCO article by Bill Gross on why they are short US Treasuries):
"Inflation is a ravaging pestilence so viral that when let in it can erode the quality of life substantially enough to alter the course of history within smitten nations. It does this by illuminating pre-existing quality-of-life issues that tend to boil beneath the surface until something brings them to the fore. Then the discontent takes on a life of its own...
In the aftermath of the financial crisis, central bankers throughout the world have not had much of an inflation battle to fight; in fact, the risk of deflation has been seen as the bigger foe, prompting central bankers to focus far more on promoting economic growth. In essence, central bankers have sought to reduce unemployment, believing their other adversary – inflation – was not even on the battlefield.
This is no longer true. Inflation is accelerating in many parts of the world at a time when central bankers are fighting other battles. The return of this old nemesis is occurring at an inopportune time, because the battle against the colossal effects of the financial crisis is not yet over. Nevertheless, to let the enemy in much further risks lasting damage to the well-being of the populace.
Central bankers therefore must alter their strategies – i.e., reduce their degree of monetary accommodation, or communicate to the public their plan to contain the inflation enemy. The latter is now essential because the public is intertwined with inflation on the battlefield, seeing the whites of inflation’s eyes with their own, prompting fear, concern and in extreme cases expressions of discontent. Failure to address these fears will strengthen the enemy.
Inflation is so powerful that when left unchecked it can infiltrate enemy lines and convince the masses to join its ranks. Such is the danger of letting inflation expectations increase substantially enough that the expectations themselves become a source of inflation. This is currently the biggest danger facing central bankers, and in some parts of the world they are getting outflanked.
The recent increase in inflation expectations in developed countries was welcome when it began, because it wasn’t the enemy – deflation and the aftershock of the financial crisis were, which is why central bankers deployed their most powerful weapons, including their conventional ammo, interest rates, and unconventional ammo, such as securities purchases, to fend off the effects of the crisis.
Early on, central banks were comfortable using this arsenal because there wasn’t much risk of collateral damage. After all, in countries such as the U.S., the gap between actual and potential growth is expected to remain large for some time (see Chart 1). Today, however, the risk of collateral damage is escalating in the financial markets, the economy, and on the world stage. If the accommodation is not reduced in time, the beneficial effects of extraordinary policy actions will morph and become deleterious, manifested in faster rates of inflation and misallocations of capital.
To battle back incipient inflation pressures, the Federal Reserve must cast aside its view that rising headline inflation will not spill over into core inflation and heed the public’s fears that it will. Expectations matter and if the Fed is to succeed in keeping inflation at bay, it must either act against inflation or communicate to the public its strategy for doing so – or else the public will become an inflation ally."
