Monthly Archives: February 2017

A year ago, Lawrence Summers’ perceptive warnings about the possibility of secular stagnation in the world economy were dominating global markets. China, Japan and the Eurozone were in deflation, and the US was being dragged into the mess by the rising dollar. Global recession risks were elevated, and commodity prices continued to fall. Fixed investment had slumped. Productivity growth and demographic growth looked to be increasingly anemic everywhere.

Estimates of the equilibrium real interest rate in many economies were being marked down. It seemed possible that the world economy would fall into a “Japanese trap”, in which nominal interest rates would be permanently stuck at the zero lower bound, and would therefore not be able to fall enough to stimulate economic activity.

Just when the sky seemed to be at its darkest, the outlook suddenly began to improve. Global reflation replaced secular stagnation as the theme that dominated investor psychology, especially after Donald Trump’s election in November. Why has secular stagnation lost its mass appeal, and has it disappeared forever? Was it all a case of crying wolf? Read more

President Trump has an almost unprecedented opportunity to reshape the key personnel and legal basis of the Federal Reserve in the next 12 months, essentially rebuilding the most important economic organisation in the world in his own image, if he so chooses.

The President may be able to appoint five or even six members to the seven-person Board of Governors within 12 months, including the Chair, Vice Chair for monetary policy, and a new Vice Chair for banking supervision. He may also be able to sign into law a bill that alters aspects of the Fed’s operating procedures and accountability to Congress, based on a bill passed in 2015 by the House of Representatives.

Not surprisingly, investors are beginning to eye these changes with some trepidation.

Some observers fear that the President will fill the Fed with his cronies, ready to monetise the budget deficit if that should prove politically convenient. Others fear the opposite, believing that the new appointments will result in monetary policy being handed over to a policy rule (like the Taylor Rule) that will lead to much higher interest rates in the relatively near future. Still others think that the most important outcome will be a deregulation of the banking system that results in much easier credit availability, with increased dangers of asset bubbles and economic overheating.

It is not difficult to see how this process could work out very badly indeed. But, at present, I am optimistic that a modicum of sense will prevail. Read more

It has been clear for a while that the most important political risk to global financial markets in 2017 will be the possible election of a President Marine Le Pen in the second round of the French elections on 7 May. Last week, this risk came into sharper focus when a small change in the odds of her winning the Presidency caused a sudden widening in Eurozone bond spreads, with the France-Germany spread reaching about half of the average levels seen during the euro crisis of 2011 (see graph).

Investors have now become accustomed to political shocks driven by swings towards populism, notably in the UK and the US last year. These experiences have led some investors to conclude that a third “populism” surprise is quite likely in France because “no-one can believe the polls any more”. But they have also tended to add that “Brexit and Trump did not disrupt the markets, so Le Pen would not do so either”.

Both of these inferences are wrong. The risk of a President Le Pen is far lower than the ex ante risk of Brexit or President Trump was last year, but the consequence of her winning would be far worse. This time, the “experts” are not exaggerating how bad it could be for markets. Read more

In mid 2016, the global economy embarked on a regime of reflation that has been dominating market behaviour ever since then. This has constituted a simultaneous rise in real output growth, along with a rebound in inflation as commodity prices have recovered from their 2014-15 slump.

The result has been a sharp increase in nominal GDP growth in most of the major economies. As the secular stagnation theme has lost its potency for investors, a decline in the perceived risk of outright deflation has triggered a rise in breakeven inflation expectations in bond markets everywhere.

One of the most important questions for 2017 is whether this bout of reflation will continue. My answer, based partly on the latest results from the Fulcrum nowcast and inflation models (see first graph), is that it will continue, at least compared to the sluggish rates of increase in nominal GDP since the Great Financial Crash.

However, the nature of the reflation theme is changing. The term “reflation” does not necessarily imply that global inflation, or inflation expectations, will continue to rise very much from here.

A likely pattern in 2017 is that there will be upgrades in consensus forecasts for real output growth, but inflation will stabilise, and will not threaten to break above central bank targets in most advanced economies.

Equities and other risk assets would probably view this as a healthy mix of output and inflation components of national income, while bond markets would probably exhibit a stabilisation in breakeven inflation expectations, with real yields rising a bit. Read more