Inflation expectations are falling in many major economies and fear is building that central banks are close to exhausting their toolkit and powerless to achieve their inflation targets. Negative deposit rates are being seen as hindering bank profitability and, in any case, there is a lower bound beyond which the withdrawal of cash becomes increasingly attractive to avoid charges. Additional sovereign bond purchases are also viewed as nearing the end of their effectiveness since yields are already at rock bottom levels and efforts to depreciate the currency are futile if many other countries are attempting to use the same approach to reflate.
However, we should not underestimate the ability of central banks to surprise us with new approaches. In a fiat money system, they have an unlimited ability to create money (electronic or paper). This cash can be deployed in a number of ways. So far it has been largely used to buy sovereign bonds, but the range of assets purchased can be expanded. The central bank could also finance government spending or tax cuts more directly. The most extreme version is a helicopter drop of money.
The economics profession is clear that inflation is a monetary phenomenon. Commodity price moves, an impaired monetary policy transmission mechanism, increased competition and globalisation are ultimately transitory influences on the price level, but not the underlying inflation rate. A determined monetary authority can always generate higher spending and positive inflation. The only constraint is political.
We believe the current panic around the global growth outlook is overdone, but if we are wrong and global growth slides below its potential, how long will it take for fiscal and monetary co-ordination to take hold? It could get worse first, but don’t bet on a deflationary abyss.