There is some evidence in the UK of a pick-up in consumer spending, probably echoed elsewhere. There are two likely factors behind this, the first perhaps being seasonal, aided by the fine weather. The second is less obvious, but combines with the first to encourage purchases of big ticket items; and this is cheap consumer finance coupled with growing expectations of higher interest rates in the future.
Interest rate expectations are therefore fuelling demand for big-ticket items, such as autos and electronic goods, where the cost of credit has been cut to maintain sales. There also appears to be growing demand for fixed-rate mortgages, and thanks to banks willing to borrow short and lend long there are some very tempting refinancing deals available. In summary, low financing costs plus a decent summer is the basis for kick-starting economic optimism.
Economists are already revising their GDP growth expectations upwards. However, there is likely to be a growing tendency for prices to rise due to capacity constraints in companies that have bolstered their profits by withholding investment for the last three or four years. Consequently price rises will be greater than generally expected.
The situation in the US is similar, with an added factor. US consumers are more responsive to confidence in stock markets and property prices than in the UK, and here the news has been bullish. Interest rates are low, and they will rise, so buy those big-ticket items now. The cost of buying and financing the average house purchase has already risen an estimated 40%.
Governments and economists will think they have the recovery they have wished for. Unfortunately it will almost certainly be marred by price inflation greater than the increase in demand suggests. So while nominal GDP growth rates will turn out to be somewhat better than currently expected, the talk will be of temporary capacity constraints.
The end result is that while central banks will realise that price inflation is a growing problem they will be reluctant to use higher interest rates to choke off inflation. And if consumers see central banks are behind this curve, further consumer borrowing will be encouraged.
This leads into the second phase of inflation. The first was expansion of cash and deposit money and the second is its mobilisation. The price effect is likely to be dramatic as money shifts from Wall Street to Main Street (or in British terms, from the City of London to the high street). However, there is an additional currency effect which few economists factor in: markets begin to discount the future purchasing power of paper currencies, bringing anticipated and higher prices forward in time, while central banks appear to be reluctant to raise interest rates. The Volcker remedy of raising interest rates to choke off inflation is simply not a policy-maker’s option.
The central banks are bound to be more focused on the damage from rising bond yields to government deficits and bank balance sheets. They will also be acutely aware of the effect higher borrowing costs has on today’s high levels of consumer debt.
The conclusion is that the central banks’ inflationary response to the banking crisis five years ago is going to get considerably more difficult in the coming months as monetary inflation morphs into price inflation.