Many major central banks changed their targets not long ago. To make sure central banks don’t tighten monetary policy too early, monetary policy will be tightened only when actual inflation will exceed the target of 2% for some time. In addition, the Fed wants to stimulate growth to the extent where the labour market tightens and wage increases end up at distinctly higher levels. Hopefully this will reduce inequality.

Globalisation has created a massive divide in the West. Those who are directly or indirectly affected by competition from low-wage countries – most notably China and the rest of Asia – have experienced a stagnation in real wage growth for many years. The introduction of new technology generally has the same effect.

By contrast, those who facilitate globalisation, or those who are not faced with competition from low-wage countries, have enjoyed significant gains in real disposable income. In addition, this group generally owns shares and/or property, and, thanks to a very loose monetary policy, prices of these assets have been going up for many years.

This has resulted in a growing divide. Many central banks in the West regard this as a very precarious situation. Indeed, people who are well off mainly vote for the centrist parties, while those who lag behind generally vote for extreme and radical parties on the left and right side of the political spectrum. This forces the moderate parties to shift in this direction, as otherwise they would lose too many votes.

Research shows that higher wage growth mainly benefits employees whose real disposable income has been stagnating for a long period of time and this suggests higher wage growth is one of the most attractive strategies to reduce inequalities. This is why central banks want wage increases and inflation to be at excessively high levels, before they hit the monetary brakes in earnest. Until then, the economy should continue to receive stimulus.

Chart 1: In the past decades, average real wages of us production workers have hardly risen

Source: Refinitiv Datastream/ECR Research

Chart 2: There sems to be growing disconnect between have and have nots due to rising asset prices

Source: Refinitiv Datastream/ECR Research

Message from the markets

The question is whether central banks have the courage to crack down on excessively high inflation. This question is particularly important at the present time, as both inflation and wage increases are under upward pressure, while monetary conditions are still more or less the same as during the low point of the corona crisis. Monetary policy may therefore well be too loose for the current circumstances, as a result of which financial markets may lose confidence that central banks will prevent inflation from spiralling out of control, resulting in rapidly rising interest rates and declining asset prices.

It is therefore quite likely that central banks will not be able to delay tapering and/or rate hikes for much longer. Tapering means that they will reduce their massive bond purchases. And then just enough to prevent inflation (expectations) from rising too rapidly, while ensuring that the economy does not fall into the abyss.

Long-term interest rates have not risen significantly. This also shows that the markets do not expect inflation to rise substantially. It is more likely to fall back according to the markets, otherwise the average inflation expectation for the next ten years would not be far lower than the current inflation rate. The markets therefore believe that the spread of corona will gradually be curbed more effectively, as a result of which many bottlenecks will disappear and inflation will fall back. However, we have a slightly different view.

The past is no guarantee for the future

Economists have too often extrapolated the past too much into the future. In the early 1980s, for example, they did not see the transition from higher to lower inflation coming and almost nobody anticipated the 2008 credit crunch.

We strongly assume that we are witnessing another important turning point. Certainly, after the credit crunch broke out in 2008, the great risk was deflation rather than inflation. This is why, since then, central banks have made considerable efforts to stave off deflation and achieve higher inflation. They have pulled out all the stops for this, however, inflation stayed well below 2% until recently.

Corona has driven inflation well above this level, but it is generally argued that the old situation will return as soon as the pandemic is under control.

A great deal has changed

We do not share this view because the situation has changed dramatically.

• Under the current central bank policy, wage increases and inflation will have to have reached excessively high levels before central banks take proper action. However, it is generally the case that inflation tends to keep rising once it is in an uptrend. As changes in monetary policy only have an impact after four to eight quarters, this means that the monetary brakes will ultimately have to be hit fairly hard. Asset prices will immediately plummet in this case, which entails the risk of another credit crunch. It is therefore doubtful whether central banks will dare to crack down on rising inflation. All the more so because rising inflation has its advantages. It will alleviate the debt burden and produce higher nominal interest rates.
• The time of globalisation is over. A growing number of political parties in the West want to protect themselves against foreign competition – via import restrictions, for example.
• The major problem following the credit crunch was that debts had risen to excessively high levels – to the extent where most parties did not want to step up borrowing, and many banks were reluctant to supply credit. Hence, more money was created than the economy was able to absorb, which subsequently flowed to the asset markets, driving up prices there. This should ultimately lead to more credit supply and therefore to higher growth (and inflation). However, more and more surplus money was required to boost asset prices to even higher levels, and ever higher asset prices were required to maintain credit supply. This is why inflation never really went up.The situation is different now because public deficits have increased dramatically and are financed with surplus money created by central banks. The surplus money no longer sits in the banks waiting to be supplied as credit, but it ends up directly with consumers and companies via the government. As a result, central banks are far better equipped to stimulate the economy.
• Needless to say, corona has led to abnormal amounts of government expenditure and therefore to exceedingly high deficits. This will gradually be scaled back. However, it will not be scaled back to any great extent because politicians do not feel enough pressure as long as central banks are willing to finance the deficits and keep borrowing costs extremely low.

It is a tough way back

In conclusion, we believe that central banks will have their way this time, and that wage increases and inflation will indeed end up at higher levels. The timing depends on developments in terms of corona (and the flu), but central banks will ultimately achieve their goal.

However, once central banks have gone down this road, the way back will be fraught with difficulty. Of course, a central bank can always combat excessively high inflation by raising its rates far enough. However, if this entails a collapse in asset prices, the cure will be worse than the disease. In practice, central banks will choose to let inflation rise further. This is why we expect long-term rates to rise further in the coming years.