Will we ever get back to ‘normal’ – normal growth, normal inflation, normal interest rates?

Our Economics Commentator says that, after seven years of ultra-easy money, we must look to America for the answers

Stanley Fischer, vice chairman of US Federal Reserve, Janet Yellen, chair, and William Dudley of the Federal Reserve Bank of New York, at Jackson Hole, Wyoming, last week (Bloomberg/Getty)

The tempo of the world of economics and finance always changes at the beginning of September. Labor Day, the American holiday that marks the informal end of the summer vacation season, is still a week away, but the annual meeting of the world’s central bankers at Jackson Hole, in Wyoming, focuses minds about the forces that will shape markets and economies in the months ahead. And this year, the prospect of US interest rates rising gives an edge. Is the US – after seven years of ultra-easy money – getting back to normal? And if so, what might that mean for the rest of us?

It matters because the US remains so overwhelmingly important. True, if you look at various national contributions to global growth in recent years, the emerging economies have been more important than the developed ones. But leadership comes from America. The dollar is still the anchor currency, for its only serious potential challenger, the euro, is too burdened by the specific difficulties of the European economy. So the European Central Bank is still expected to ease policy later this year, while the Federal Reserve will tighten.

What the US will do to interest rates, however, is really a subsidiary question. The primary one is: what will happen to inflation? It is very simple. If inflation raises sharply in the US, rates will rise sharply too. That applies to the UK as well, notwithstanding the recent action by the Bank of England. The monetary policy committee cut rates and reintroduced quantitative easing (QE) because it thought the post-Brexit economy might tank. If it does reasonably well and inflation starts to climb again, then policy will have to be reversed.

Inflation predictions for the US, as elsewhere, have proved quite wrong. After seven years of spraying money around, the world’s central banks ought to have generated massive inflation. That hasn’t happened, or rather it hasn’t happened to current inflation. It has happened to asset inflation, with the price of property, equities and bonds now more than 50 per cent higher worldwide than they were seven years ago. We have experienced this in Britain, with house prices, shares and bonds at or close to record levels, but very little rise in current prices or indeed in wages.

So the fascinating, puzzling, tantalising question concerns the links between asset inflation and current inflation. Asset inflation ought to lead to current inflation, and it has in the past. You cannot sustain high house prices indefinitely if wages are too low for people to buy the houses. But house prices won’t fall if the central banks keep printing money and rates stay low. We don’t really understand the transfer mechanism, which makes it hard to predict how things might play out now.

We do however know where to look, and that will be America. Inflation in the US does seem to be creeping up. The most recent figure for current inflation is only 0.8 per cent. But core inflation, which excludes volatile items including food and energy, is now 2.2 per cent compared with 1.6 per cent at the beginning of last year. You can sketch a gradual return of headline inflation to above 2 per cent over the next couple of years. But you would have to have years of 2 per cent inflation, and perhaps 3 to 4 per cent increases in wages, to bring the relationship between pay and house prices back to where they were in the 1990s.

The implication of this is that, while the US will gradually get back to more normal interest rates and more normal inflation, interest rates will remain relatively low – relative that is to historical levels – for a long time. That is the assumption here too. But low interest rates create problems and the longer they stay low the more the problems mount. We can see that in the UK with the pressure on pension funds from ultra-low rates on government securities.

So through the autumn the world will be looking to America for guidance. Can the US engineer a gradual rise in rates, allow inflation to creep up, and keep growing at a decent clip? If it does, then the rest of the developed world can expect to tag along behind. Of course the UK and European policy-makers will be preoccupied by the Brexit debate. To be realistic, there is likely be some negative impact from Brexit on both economies, with the eurozone possibly taking a greater hit than the UK. But the US getting back to normal – normal growth, normal inflation, normal interest rates – would be unequivocally good news for the rest of us. Normal politics? Ah, that is another matter.