Introduction: A Deep Analysis of the causes, consequences and Impact on long-term interest rates of global low Inflation!
Since the beginning of this year, global reflation and monetary policy contraction have become the focus of attention. So, from the perspective of long-term interest rates, has the underlying logic changed? This article studies the causes and consequences of low inflation and its impact on long-term interest rates.
In recent years, the world has quietly entered an era of low inflation. Neither the improvement in economic output nor employment data can reverse the situation of low inflation. The global low inflation is mainly influenced by the decline in commodity prices, technological innovation, an aging population and idle labor force. Firstly, the prices of goods such as food and energy have a relatively large weight in the CPI, so the trend of commodity prices has a significant impact on inflation. Since the beginning of this year, the S&P GSCI Commodity Index has dropped by nearly 15% cumulatively, and the settlement price of Brent crude oil futures has also fallen by 10%. Secondly, globalization and technological innovation have reduced production costs, exerting a negative impact on inflation.
On the one hand, the advancement of trade globalization has led labor-intensive industries to shift to places with lower costs, and the return of low-priced goods will cause an effect similar to “imported deflation”. On the other hand, the rise of Internet technology has compressed the intermediate links in the supply chain, further reducing the prices of goods. Secondly, the rise of the part-time job craze has exacerbated the relaxation of the labor market, leading to a sluggish growth rate of salaries. Since the 2008 financial crisis, the rise of the part-time job craze has led to a certain degree of “distortion” in the official unemployment rate. A mere decline in the official unemployment rate does not necessarily lead to an improvement in the situation of idle labor, and thus the upward momentum of wages and inflation is limited.
Finally, with the decline in birth rates and the increase in life expectancy, the global trend of population aging is intensifying. This will reduce the consumption and investment propensity of the entire society, leading to insufficient total demand. Overall, the factors contributing to global low inflation are mostly structural. The negative impact of these factors on inflation is long-term and difficult to reverse. Therefore, it is expected that global inflation will remain at a low level for a relatively long time.
The greatest danger brought by low inflation is deflation, and deflation is very likely to lead to an economic recession. Low inflation may have a secondary impact on wage and price setting, causing a deflationary spiral. Deflationary expectations will reduce and delay investment and consumption, and cause wealth to shift from debtors to creditors. In the long term, this will strangle economic growth and lead to an economic recession.
Global low inflation means that the upward pressure on bond yields to maturity is not significant, which is beneficial to the bond market. First of all, the persistently low inflation has lowered investors’ expectations for future inflation. Secondly, low inflation implies that monetary policy will tend to be loose. Central banks of all countries take price stability as the main goal of monetary policy, aiming to curb inflation as well as prevent deflation. The simultaneous maintenance of the original monetary policies by the central banks of Europe and Japan yesterday indicates that there is still a need to continue the loose monetary policy before inflation rebounds to an appropriate level.
Secondly, low inflation may lead to an economic recession, causing a rise in risk aversion and highlighting the value of bond allocation. During an economic recession, income, prices and market interest rates all enter a downward channel, and interest rate cuts and other factors lead to a rapid decline in the yield curve. Bonds will then become the best choice. Finally, the normalization of monetary policy is an inevitable path for all countries, but it will have to wait until inflation rebounds. The current negative interest rates and overly bloated balance sheets are not the norm of monetary policy. The normalization of monetary policy, from the exit of quantitative easing to gradual interest rate hikes and finally to balance sheet reduction, is an inevitable path for every country’s monetary policy. However, when the normalization of monetary policy begins, what the path is, and how fast the pace is largely depend on the inflation situation.
Given the current persistently weak global inflation, central banks around the world are likely to maintain their current loose policies and wait for inflation to return to the target level. The core logic that determines the global interest rate level is low inflation. The normalization of monetary policy may cause certain disturbances to the global interest rate level, but it cannot change its fundamental logic.
Regarding the bond market, under the combined effect of multiple structural factors, global low inflation is likely to persist for a relatively long time, which may lead to deflation and economic recession. Against this backdrop, the upward pressure on bond yields to maturity is not significant. On the one hand, the safe-haven value of bonds has become more prominent. On the other hand, the monetary policies of central banks around the world tend to be loose. Overall, the core logic that determines the global interest rate level is low inflation. The normalization of monetary policy may cause certain disturbances to the global interest rate level, but it cannot change its fundamental logic. We insist that the range of 3.2% to 3.6% for the 10-year Treasury bond yield remains unchanged.
Since the beginning of this year, global reflation and monetary policy contraction have become the focus of attention. So, from the perspective of long-term interest rates, has the underlying logic changed? This article studies the causes and consequences of low inflation and its impact on long-term interest rates.
In recent years, the world has quietly entered an era of low inflation
Although economic output or employment data in various countries have improved to varying degrees, the inflation level remains low. Domestically, since June 2016, the year-on-year growth rate of industrial added value above designated size in China has remained above 6%, and in the past four months, it has maintained a relatively high growth rate of over 6.5%. However, the CPI has remained moderate, increasing by 1.5% year-on-year, with the growth rate dropping by 0.38 percentage points compared to the same period last year. Internationally, although the employment in the United States far exceeded expectations, the hourly wage in June was 0.2% month-on-month, marking the third consecutive month of falling short of expectations. Moreover, the previous value was revised down from 2.5% to 2.4%. Japan’s industrial output in May continued the excellent performance of April, increasing by 6.8% year-on-year, but the CPI remained low, rising by only 0.4% year-on-year. The unemployment rate in the eurozone dropped to 9.3% in May, hitting an eight-year low, but inflation was only 1.3%, falling short of the policy target of 2%.
Second, the global low inflation is mainly affected by the decline in commodity prices, technological innovation, aging population and idle labor force
First of all, the decline in commodity prices has a significant impact on inflation. Food, inflation and other commodities have a relatively high weight in the CPI index. In 2017, the prices of food, tobacco and alcohol accounted for 30% of China’s CPI, while the weights of energy and food in the harmonized CPI index of Europe reached 9.5% and 19.6% respectively. Therefore, the prices of food and energy have a significant impact on the trend of inflation. Since the beginning of this year, the S&P GSCI Commodity Index has dropped by nearly 15% cumulatively, and the settlement price of Brent crude oil futures has also fallen by 10%, from $55.47 per barrel at the beginning of the year to the current $49.70 per barrel. It becomes a major fluctuation factor.
Secondly, globalization and technological innovation have reduced production costs, exerting a negative impact on inflation. On the one hand, with the continuous advancement of trade globalization, labor-intensive industries are accelerating their transfer to regions with lower costs. The return of low-priced goods will cause an effect similar to “imported deflation”, that is, a phenomenon where domestic prices remain low due to the decline in the prices of foreign goods or production factors. On the other hand, the rise of Internet technology has compressed the intermediate links in the supply chain, further reducing the prices of goods. According to a report by the European Central Bank in 2015, e-commerce has had an annual impact of -0.1% on the inflation rate over the past decade, exerting a significant weakening effect on the already low inflation rate in the Eurozone. According to data from the US Bureau of Statistics, Verizon’s decision to offer unlimited data packages pulled down the core inflation rate in the US by a full 0.2 percentage points in June. Although it seems to be a one-off accidental factor, it is closely related to the development of communication technology behind it.
Secondly, the rise of the part-time job craze has exacerbated the relaxation of the labor market, leading to a sluggish growth rate of salaries. According to the Phillips curve, there is a certain substitution relationship between inflation and unemployment rate. However, the decline in unemployment rates in various countries in recent years has not been reflected in wage growth. One of the reasons is that the job market is not as strong as the unemployment data suggests. Since the 2008 financial crisis, the rise of the part-time job craze has given employers greater flexibility. Most companies are adding more part-time positions and recruiting more temporary workers instead of handing over extra work to current employees.
According to a research report released by the European Central Bank in May 2017, since the financial crisis, the number of part-time and temporary workers employed has increased by nearly 4 million, while the total number of employed people has not shown a growth trend. The working hours and intensity of part-time and temporary workers are often lower than their employment intentions, and their wages are also much lower than those of regular employees. Therefore, they are considered idle labor force. Although their existence has not been included in the official unemployment rate statistics, it still aggravates the degree of relaxation in the labor market and becomes a potential factor that restrains wage growth. The large number of part-time and temporary workers has led to a certain degree of “distortion” in the official unemployment rate. A decline in the official unemployment rate does not necessarily lead to an improvement in the situation of idle labor, so the upward momentum of wages and inflation is limited.
Finally, population aging reduces the propensity to consume and invest, and insufficient aggregate demand curbs inflation. With the decline in birth rates and the increase in life expectancy, the global aging trend is becoming increasingly evident. According to the 2017 World Population Prospects report released by the United Nations, the population aged 60 and above in Japan has accounted for 33% of its total population, 29% in Italy, and 28% each in Portugal, Bulgaria and Finland, ranking among the countries with the most severe aging population problems in the world. The aging trend of the population in China is also accelerating further. The population aged 60 and above accounts for 16% of the total population. The report predicts that by 2050, the elderly population in Europe will account for 35% of the total population in the region. The conservative and risk-averse characteristics of the elderly make them have a high willingness to save but a weak willingness to consume and invest. The insufficient total demand of the whole society will curb the upward trend of inflation.
Overall, the factors contributing to global low inflation are mostly structural. The impact of these factors on inflation is long-term and difficult to reverse. Therefore, it is expected that global inflation will remain at a low level for a relatively long time.
The greatest danger brought by low inflation is deflation, which will seriously harm the economy
Low inflation may have a secondary impact on wage and price setting, causing a deflationary spiral. On the one hand, low inflation means that commodity prices remain at a low level, the growth rate of producer profits is relatively low, market confidence and investment willingness are insufficient, and as a result, employees are willing to leave their jobs, leading to an increase in the unemployment rate. Employees’ bargaining power in salary negotiations with employers decreases, and thus the growth rate of wages further slows down.
On the other hand, if salary growth remains stagnant and cost increases are weak, there is little necessity for enterprises to raise prices. The sluggish growth rate of wages will be passed on to the prices of terminal goods, leading to a further reduction in the inflation level and once again causing a slowdown in the growth rate of wages. If this situation persists, low inflation is very likely to evolve into deflation.
Deflation expectations will reduce and delay investment and consumption, and cause wealth to shift to creditors, which will strangle economic growth in the long term. Firstly, when the nominal interest rate remains unchanged, deflation will raise the real interest rate, causing the real financing cost to rise accordingly and leading to a reduction in investment. Meanwhile, with prices tending to decline, people expect the replacement cost of projects to decrease, thus delaying current investment and reducing the start of new projects in this period.
Secondly, deflation has both price and income effects on consumer demand, and the superposition of these two effects mostly leads to consumers delaying or reducing their consumption. The price effect is reflected in the fact that the decline in prices enables consumers to obtain the same quantity and quality of goods and services at a lower price, while the expectation that prices will fall further in the future prompts them to postpone consumption. The income effect is reflected in the fact that employment expectations and wage income tend to decline due to the slowdown in economic growth, and the reduction in income will prompt consumers to cut back on their spending.
Finally, although the nominal interest rate is low, due to negative inflation, the real interest rate is often higher than during inflation, causing wealth to shift from debtors to creditors and increasing the burden on debtors. Overall, deflation expectations will reduce investment and consumer demand in this period. Insufficient total demand will create pressure for supply contraction, and the negative output gap will continue to increase. The national economy may enter a recession.
Fourth, global low inflation means that the upward pressure on bond yields to maturity is not significant, which is beneficial to the bond market
Persistent low inflation has lowered investors’ expectations for future inflation. The yield to maturity of bonds is determined by the risk-free interest rate, inflation expectations, risk premium, term premium, etc. Under the condition that other factors remain unchanged, persistently low inflation will lower investors’ expectations for future inflation and prompt them to demand a lower rate of return. Market forces will drive down bond yields to maturity.
Low inflation means that monetary policy will lean towards easing. Price stability is the main goal of monetary policy, and the global standard for price stability is an inflation level of 2%. That is to say, when the inflation level exceeds 2%, monetary policy should be committed to curbing inflation, while when the inflation level is far below 2%, monetary policy should remain loose; otherwise, deflation will intensify. On July 20, 2017, the European Central Bank (ECB) kept its three major interest rates and the scale of asset purchases unchanged as expected. At the same time, the ECB stated that if the economic outlook deteriorated, it would consider increasing the scale of quantitative easing (QE) and extending the duration of QE until the inflation path was consistent with its policy goals.
On the same day, the Bank of Japan decided to postpone the achievement of the 2% inflation target from the previous “around fiscal year 2018” to “around fiscal year 2019”, and continue to implement a forceful loose monetary policy. The measures taken by the central banks of Europe and Japan to maintain loose monetary policy indicate that it is still necessary to continue the loose monetary policy until inflation rebounds to an appropriate level.
Low inflation may lead to an economic recession, causing a rise in risk aversion and highlighting the value of bond allocation. The Merrill Lynch Clock model, by studying the levels and changes of economic growth and inflation, defines the economic cycle into four stages: recession, recovery, overheating and stagflation. The most valuable asset classes for allocation are bonds, stocks, commodities and cash respectively. During the recession period, the economic growth rate is lower than the potential growth rate, and the negative output gap keeps expanding. Insufficient market demand and weak corporate profitability result in a relatively low actual rate of return. Excess production capacity and falling commodity prices have pulled down the inflation rate. Under this, macroeconomic policies tend to favor loose monetary policies and proactive fiscal policies. Therefore, income, prices and market interest rates have all entered a downward channel, and interest rate cuts and other factors have led to a rapid decline in the yield curve. Bonds will become the best investment option.
The normalization of monetary policy is an inevitable path for all countries, but it will have to wait until inflation rebounds. The current negative interest rates and overly bloated balance sheets are not the norm of monetary policy. The normalization of monetary policy, from the exit of quantitative easing to gradual interest rate hikes and finally to balance sheet reduction, is an inevitable path for every country’s monetary policy. However, when the normalization of monetary policy begins, what the path will be, and how fast the pace will be largely depend on when the inflation level recovers.
Given the current persistently weak global inflation, central banks around the world are likely to maintain their current loose policies and wait for inflation to return to the target level. Moreover, even if monetary policy normalizes, it does not imply tightening and has a limited impact on the long-term trend of the bond market. The core logic that determines the global interest rate level is low inflation. The normalization of monetary policy may cause certain disturbances to the global interest rate level, but it cannot change its fundamental logic.
Bond market strategy
Since 2017, the world has quietly entered an era of low inflation, mainly affected by the decline in commodity prices, technological innovation, aging population and idle labor force. Most of these are structural factors that have a relatively long-term impact and are difficult to reverse. Therefore, it is expected that global inflation will remain at a low level for a relatively long time.
The greatest risk of global low inflation is deflation and recession. Against this backdrop, it is expected that the upward pressure on bond yields to maturity will not be significant. On the one hand, during economic recessions, the safe-haven value of bonds becomes prominent.