Forget overkill. Central banks still way behind

Expectations of how much central banks will push interest rates higher to get inflation under control have increased to such an extent that some are starting to talk about overkill. Markets now think that benchmark rates in the US will top out at about 4.7% (from 3.25% now), 3% in the euro zone (from 1.25%), and 5.8% in the UK (from 2.25%). Partly as a result — though also because energy prices have fallen — expectations for inflation over the next five years has tumbled.
That combination is why expected real rates — yields on conventional bonds minus the expected inflation — have spiked higher. Perhaps unsurprisingly, the UK has led the pack, and over the past year expected five-year real yields have risen an extraordinary five percentage points. But the surge in expected US real yields has not been far behind. This vertiginous rise has clobbered financial assets and led to all the muttering about overkill. The extraordinary thing about rates, though, is not how high they are but how low. They will have to increase much more to get inflation sustainably lower.
A big reason for the expected drop in inflation is that investors big and small were used to a world in which disinflation seemed more of a problem and think it won’t take much to bring it back. The same is true of central banks and, strange as it may seem, they still have a lot of credibility.
Broadly speaking, these views are supported by three main arguments. The first is that you can’t get much inflation given the unprecedented amounts of debt outstanding in the world today. What people generally mean by this is the expense of servicing all that debt at higher interest rates would rapidly eat into demand and thus growth. However you cast the argument, it is wrong. Simply put, if nominal growth is much higher than nominal rates, debtors are in heaven and creditors in hell. There are exceptions, such as highly leveraged companies, governments that link lots of pensions to inflation, or households in the UK borrowing at floating rates. But unexpectedly strong inflation mainly clobbers creditors. Look for evidence at the appalling real returns on bonds over the past couple of years.
The second argument is that the amount of money sloshing around in developed economies is rapidly slowing, thereby choking the life out of both growth and inflation. The problem with this argument is twofold. The first is that it confuses stocks and flows. While money growth is indeed slowing, the stock of money remains very high. The second is that monetarists aren’t good at accounting for the velocity of that money, or how fast it circulates around the economy. Having fallen like a rock for many years, velocity is picking up, supporting inflation pretty much by definition.
The third argument is that slower economic growth will bring inflation rates down. Certainly, most of the developed world has been slowing and China has fallen into a very deep hole, cutting global demand. The Bloomberg Commodity Index is down more than 15% since June and West Texas Intermediate oil prices by about 25%. Together with energy price caps in many countries, this is likely to reduce headline consumer inflation.
But I have severe doubts the slowdown in growth will be enough to bring inflation down to the sort of levels markets expect, let alone tackle how much it has spread from the initial supply shocks.
—Bloomberg