Chris Iggo at AXA IM still sees no inflationary threats in Europe

Chris Iggo, CIO of Fixed Income at AXA IM, says that there are few signs of inflationary pressures developing across Europe in the near term.

For all the talk of forward guidance and macro-prudential supervision, central bank policy will ultimately be driven by what happens to inflation and unemployment relative to the levels that central banks think are socially optimal. We are still at sub-optimal levels in most developed economies – either because inflation is too low (and falling) or because unemployment is too high, or both.

Given the reaction of the markets to the “tapering” scare in June, the Fed might now see “tapering” as “tightening” and wait to see more progress on falling unemployment before it acts. This could be months away. So, hang on to your hats and enjoy the liquidity driven rise in asset prices for a bit longer. With the Fed on hold, global growth still looking reasonable and valuations more attractive, it could be the emerging markets are the place to be again.

Do inflation and unemployment trends point to higher yields?

Not yet, on the whole – If we take at face value that the key framework for fundamental monetary policy decision making is some kind of Taylor rule, then long term asset allocations decisions should pay attention to trends in unemployment rates and inflation – the key macro variables for central bankers.

The Taylor rule is fundamentally a way of expressing how monetary policy should be set given the alignment or otherwise of current unemployment and inflation rates with the long-term targets that are seen to maximise social utility. For all the noise provided by discussions about forward guidance or the timing of tapering, the medium term trends in interest rates will be determined by how central banks react to trends in these key macro variables. If inflation is well below target and unemployment is well above target, then it is hard to think about any tightening of monetary policy and, given the current extremely accommodative stance of most developed world central banks, that means very low interest rates for some time to come. So it is worth considering where we are relative to desirable levels of unemployment and inflation and whether or not we are moving towards those targets or not. With unemployment remaining at a record high in the Euro Area at 12.2% in September and CPI inflation at 0.7% year on year there is a strong argument that the ECB’s monetary policy remains too tight.

At the other extreme, Japan’s unemployment rate is a mere 4.0% and it has experienced a rapid rise in its inflation rate from -0.9% year on year in March to +1.0% year on year in September in response to the Bank of Japan’s high octane QE. It would certainly be a turn-up if Japan started to end QE before the United States! Unlikely, given Japan has only recently started QE, but interesting that its seems to have been able to create some upside momentum in inflation over the last year.

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