Macroeconomics

For many years, investors have been in thrall to the central banks. But recently this has started to change. In particular, the excursion into negative interest rates has caused alarm in the markets.

There is much talk that monetary policy has run out of ammunition. This talk surfaces as frequently in discussions with central bankers themselves as it does with investors. To quote the title of Mervyn King’s riveting new book, is this “The End of Alchemy?”

Last Thursday, the ECB announced a new package that included a rate cut deeper into negative territory. After initial doubts, the equity markets were impressed, because Mr Draghi had learned the lessons of past failures. The package cleverly protected the banks against the effects of negative rates, drew a line under further rate cuts, and instead included a boost to the ECB’s balance sheet that is likely to be much larger than markets initially realised (see graph below).

At the ECB, negative rates are probably now dead, but other forms of “alchemy” are still very much alive.

 Read more

BELGIUM-EU-SUMMIT

Mario Draghi, ECP president  © Getty Images

Even central bankers can learn from their past mistakes. The package of measures unveiled on Thursday by the European Central Bank is an intelligent response to the criticisms levelled against it for the debacle of its previous, underwhelming easing in December, and against the Bank of Japan for its misguided experiment with negative rates last month.

The announcement by Mario Draghi, ECB president, represents just about the best effort that can be adopted nowadays to use unconventional monetary policy to restore inflation to target. It is not overly huge in scale, but is multi-faceted and well directed at the special problems plaguing the eurozone economy. Read more

A few months ago, this blog commented that a rise in inflation in the advanced economies early in 2016 was “almost certain”. Thank goodness for the word “almost”. Since then, oil prices have plumbed new depths, and the markets have remained obsessed with fears about deflation.

The case for higher inflation in 2016 rested on the fact that the impact of energy on headline consumer price inflation would change direction when oil prices stabilised. This “inevitable” arithmetic effect has been delayed by the slump in oil prices in January, but it should manifest itself in the near future.

The key question, though, is whether this automatic rise in headline inflation presages a more important turning point for underlying inflation in the advanced economies – a turning point that has been wrongly predicted for several years now.

The answer is that there are some tentative signs of a slow rise in underlying inflation in the US, where price increases have been higher than expected in recent months. In contrast, inflation rates in the Eurozone and Japan have surprised on the low side. There, fears of “secular stagnation”, leading to deflation, still seem all too real. Read more

Global risk assets have rallied in the last two weeks, encouraged by signs of policy changes in China and the US Federal Reserve, and also by buoyancy in retail sales growth in the US. While this has reduced the markets’ assessment of global recession risk, compared to the dark days in early February, the Fulcrum “nowcast” models have actually moved slightly in the opposite direction. Full details of the monthly nowcasts are available here.

The world economy is still very far from a recession, but the nowcasts show clearer signs of a slowdown in global activity growth. This probably started in early 2015, but the downward momentum has gathered pace since the beginning of 2016. The model’s estimates of global GDP growth (blue line) have declined from 3.4 per cent in late 2015 to 2.9 per cent now, a development which warrants careful monitoring.

It is clear that the advanced economies have slowed significantly since last November.

The estimated US growth rate has remained sluggish at around 1 per cent, so growth in the advanced economies has continued to decline, and is now running at only 1.0 per cent, which is markedly below trend and still dropping. It is true that some alternative estimates for US growth (including the Atlanta Fed nowcast) suggest that the growth rate may have rebounded from 1 per cent in 2015 Q4 to about 2 per cent in the current calendar quarter. But the Fulcrum models have done a good job in identifying the continuous US slowdown in the past 12 months, so their bleak message should not be discounted.

The key change this month is a further decline in the growth rate in the eurozone. This is a distinct change in the pattern identified by the models in late 2015, when the eurozone was the strongest of the major advanced blocs. This situation has changed sharply in the past two months, with the German economy becoming markedly weaker. Read more

As Paul Krugman pointed out a year ago, a sharp difference of views about US monetary policy has developed between two camps of Keynesians who normally agree about almost everything.

What makes this interesting is that, in this division of opinion, the fault line often seems to be determined by the professional location of the economists concerned. Those outside the Federal Reserve (eg Lawrence Summers, Paul Krugman, Brad DeLong) tend to adopt a strongly dovish view, while those inside the central bank (eg Janet Yellen, Stanley Fischer, William Dudley, John Williams) have lately taken a more hawkish line about the need to “normalise” the level of interest rates [1].

My colleague David Blake suggested that this blog should carry a Galilean “Dialogue” between representatives of the two camps. Galileo is unavailable this week, but here goes. Read more

China's Central Bank Governor Zhou Xiaochuan Holds A Press Conference

Zhou Xiaochuan, PBoC governor  © Getty Images

The long and detailed interview given by the People’s Bank of China governor, Zhou Xiaochuan, to Caixin Weekly on Tuesday is in one sense very un-Chinese. It provides a much more fulsome statement of foreign exchange policy, as viewed from the central bank, than anything available in the past. After months in which the governor has been conspicuously absent from the public fray, he has now chosen to go on the attack.

Mr Zhou sees the recent exchange rate crisis as out of line with economic fundamentals in China, and for that reason essentially temporary. He describes a new currency regime that is best characterised as a dirty floating regime, measured against the renminbi basket, not the dollar. “Speculative” attacks on that regime will be opposed and defeated by the central bank. In the longer term, the peg against the basket can be adjusted if fundamentals change, and the links between the two will be explained in more detail in the future.

This statement will further reduce the risk of a competitive devaluation of the renminbi in the near term. But does that mean that the China currency crisis is over? Read more

The dismal performance of asset prices continued last week, despite a rebound on Friday. There are many different forces at work, but recently the focus has turned to the weakening US economy. This weakness seems to be in direct conflict with the continued determination of the Federal Reserve to tighten monetary policy.

Janet Yellen’s important testimony to Congress on Wednesday acknowledged downside risks from foreign shocks, but overall her attitude was deemed by investors to be complacent about US growth. (See Tim Duy’s excellent analysis of her remarks here.)

Why is the Federal Reserve apparently reluctant to respond to the mounting recessionary and deflationary risks faced by the US? It is human nature that they are reluctant to admit that their decision to raise rates in December was a mistake. Furthermore, they believe that markets are often volatile, and the squall could yet blow over.

But I suspect that something deeper is going on. The FOMC may be underestimating the need to offset the major dollar shock that is currently hitting the economy. Read more

The weakness in global risk assets that started in May 2015 raises a major question for macro-economists. Is market turbulence foreshadowing – or perhaps causing – a much broader weakening in global economic activity than anything seen since 2009?

Until now, the Fulcrum activity nowcasts have failed to identify a major turning point in global growth. This conclusion is still just about intact, but is subject to much greater doubt in this month’s report. There are some signs that growth in the advanced economies may be fraying at the edges, and China may be embarking on another mini downturn.

Summary

The growth rate in global activity remains broadly unchanged at around 2.8 per cent, little different from the rates recorded since mid 2015. However, there has been a further slowdown in economic activity in the advanced economies (AEs), which are growing at only 1.2 per cent, down from 1.6 percent late last year.

For the first time since 2012, the growth rate in the AEs is clearly below trend (estimated at 1.7 per cent). Furthermore, the US nowcast is now at its lowest since the recovery began in 2009.

The nowcasts have warned of a noticeable slowdown in the US for many months, and they continue to suggest that American activity is expanding at only about 1.2 per cent, little changed from the 2015 Q4 estimate.

Until now, however, this drag on global activity has been offset by fairly robust growth rates in the Eurozone. Worryingly, Eurozone growth has now sagged to about 1.3 percent. Although this remains above the US growth rate, it no longer provides a strong counterpoint to American weakness, according to the models.

This development reduces our confidence that the bout of American weakness in the industrial sector will be easily shrugged off by the global economy. Significant downgrades to consensus forecasts for US growth in 2016 now seem very likely. Although the risk of an outright recession still seems contained, the Fed must surely sit up and pay attention to this.

We judge that there has been little change in overall activity in the emerging markets this month. The China nowcast has moved down to the lower end of its recent range, but there are clear signs of stabilisation in Brazil – by far the weakest of the G20 economies last year – and an up-tick in growth in India.

Full details of all the latest nowcasts are attached here. (Apologies for greater length than usual this month; there is a lot going on.) Read more

The grisly month of January, 2016 in the global financial markets has ended on a somewhat brighter note. Risk assets bottomed on 20 January, and since then they have recovered almost half of the losses incurred earlier in the month. Nevertheless, global equities still fell by over 5 per cent in the month as a whole.

The partial recovery has been triggered by a series of policy adjustments in China, the oil market, and the major central banks, all of whom have shifted in a more dovish direction in recent days.

The latest to act is the Bank of Japan (BoJ), which introduced a new flavour of monetary easing on Friday. They have given it a snappy title: “Quantitative and qualitative monetary easing (QQE) with a negative interest rate”. Roughly translated, they are still throwing the monetary kitchen sink at the economy, and have hinted that they might even increase the scale of the stimulus later in the year.

Some analysts have described the latest surprise announcement as “a very big regime change”. Compared to what has come before, that is probably an overstatement. On the Richter scale of unconventional monetary policy changes, it is not as significant as the two great Kuroda bazookas in April 2013 and October 2014, both of which had profound market consequences.

But it does introduce a new “tiered” approach to the implementation of negative interest rates that might allow much greater cuts into negative territory than previously envisaged by the major central banks, notably the ECB (which seemed to consider, and then reject, a similar course of action in December). Read more

Before Friday’s relief rally, the recent severe market turbulence had three distinct phases. It started with concerns about Chinese exchange rate policy. Then came a renewed collapse in oil prices. Finally, last week, came increased fears of a persistent slow-down in the US economy, following weak activity data from the US industrial sector.

The last of these factors is perhaps the most serious for the markets, since it represents the first genuine reason to worry that an important part of the global economy might actually be weakening. Until now, the bear phase in equity markets has not been backed by much evidence of a slow-down in global activity, though our “nowcasts” have been warning for some time that US growth has been out of line with the global aggregate, and is heading in the wrong direction.

The markets have tended to agree with the Federal Reserve in viewing this as a temporary dip, driven largely by specific drags on the US manufacturing sector. But now investors are starting to worry that the slow-down could become much more persistent than previously believed. The drags from oil output, foreign demand and the rising dollar are proving to be more negative for the economy than forecasters, including the Fed, have recognised. Read more

The 9 percent drop in global equity prices in the first two weeks of 2016 is certainly alarming, even for those of us who believe that the outlook for the world activity has not deteriorated much recently. The fundamental cause is the same as it was last August – a clash between a severe loss of credibility in Chinese economic policy and a Federal Reserve that still seems determined to continue tightening US monetary policy without much regard to international risks and a slowing domestic economy (see the hawkish Bill Dudley speech on Friday). Oil prices are also playing a part, but only a bit part, in my view.

The key question is whether China can restore confidence in its exchange rate policy, not least among its own citizens. For as long as a renminbi devaluation of unknown size continues to overhang the markets, an abatement in capital outflows, and a return to stability, seems difficult.

It is even possible that the event that markets most fear – a controlled depreciation of 10 per cent or so – might be the only way of restoring calm, if accompanied by other reforms. Until the renminbi is deemed by the global financial system to be at a sustainable level, fear of disruptive change will dominate sentiment. Read more

The first week of market trading in the new year has seen alarming declines in risk assets – the largest early January falls since records began in some markets. This outbreak of bearishness has no doubt been driven by further falls in oil prices and the weakness of the renminbi, both of which could lead to major financial dislocations across the world. But a really large bear market in global equities and credit is unlikely to take hold unless and until there is a major weakening in global economic activity.

So far, our regular monthly “nowcasts” of economic activity, which are updated in full here, have not picked up any decline in global growth, compared to the average recorded in recent quarters.

The overall growth rate in global activity is now running at roughly 3 per cent, which is actually slightly higher than than the growth rate recorded in 2015 Q3, the date of the previous global market scare. This conclusion is strengthened by the latest industrial production data, which show that the global IP growth rate has rebounded to about 2 per cent, compared to -2 per cent about a year ago.

The results for individual countries this month do not support widespread fears of a hard landing in China, but (surprisingly) they do identify a progressive slowdown in the US. This would become worrying for markets if it persisted into 2016 Q1, especially if it continued to be ignored by the Federal Reserve.

European growth remains robust (by its own tepid standards). In fact, the large gap in activity growth between the eurozone and the US is unusual, and is counter to the recent changes in monetary policy in the two blocs. This growth pattern needs to change in coming months if the Fed/ECB “divergence” in monetary policy is to take its expected course this year. Read more

The risk of a large devaluation in the Chinese renminbi is once again spooking markets, which are firmly convinced that this as a very bad contingency for global risk assets in 2016. As last year ended, investors became more relaxed about the threat, following a series of veiled announcements from the PBoC about its currency strategy. These statements seemed to suggest that the central bank would broadly stabilise the effective exchange rate against a currency basket from now on, while allowing greater flexibility against a (possibly) rising dollar.

Since the dawn of the new year, however, investors have become much more concerned that a larger devaluation may be in the works, either through the choice of the Chinese authorities, or because the outflow of private capital is getting out of hand. Some bears in the currency markets believe that China could soon be suffering from a genuine exchange rate crisis, in which its enormous foreign exchange reserves could be quickly drained.

That would indeed be a severe shock to global markets, since it would effectively export the deflationary forces that are overpowering the Chinese manufacturing sector to the rest of the world, and would probably require direct measures to restore the health of the Chinese financial system. But it still seems unlikely to happen, for now at least. Read more

Most investors have been able to muster only two cheers for the year that has just ended.

In 2015, the performance of the main asset classes just about managed to maintain the broad pattern that has been seen since the equity bull market started in March 2009 but there are now definite signs of market fatigue. And although some major trends were obvious in retrospect — weak oil prices, falling euro, rising dollar, tumbling emerging currencies – they recorded sharp reversals that many macro investors failed to navigate in real time.

Global equities returned about 2 per cent in local currency terms [1], less than in recent years. In dollar terms, returns were slightly negative and market peaks in May 2015 have not yet been re-attained. A top may be forming, but as yet there is little sign that a major bear market trend has started.

Government bonds returned about 1 per cent, defying widespread predictions of a trend reversal, and yields were almost exactly flat during the year. Commodity prices plummeted by 33 per cent, continuing the crash that started in mid 2014, and they eventually took credit markets down with them. US high yield securities, for example, returned -9 per cent in 2015. Emerging markets (with the perplexing exception of Chinese equities, the best performing of the major markets) were also hit by the commodity melt-down and generally continued to under-perform developed market assets, in equities, credit and currencies.

Overall, then, the magic mix of moderate gross domestic product growth combined with extremely easy monetary conditions has continued to work in the developed markets. However, overall global asset market returns (bonds plus equities in local currencies, equally weighted) were only about 1.5 per cent, suggesting that some of the magic is wearing thin.

Looking ahead, it seems likely that 2016 will, at best, see similarly low asset returns. That, anyway, is overwhelmingly the consensus central view among mainstream forecasters. But as the bull market matures, it seems inevitable that one year soon we will experience a major setback to asset prices. Will 2016 be that year? Read more

It would be tempting to ascribe the large drop in global risk assets last week to the onset of Federal Reserve tightening and a further meltdown in commodity prices. No doubt these factors played a part, but the dominant force was probably the same one that shook the markets in August – the fear of a sudden devaluation of the Chinese renminbi. This would export deflationary forces from China’s industrial sector to the rest of the world, and would interact very badly with the start of a monetary tightening cycle in the US. Read more

As one day shocks go, the market reaction to the ECB’s announcements on Thursday was very dramatic. The 4.5 per cent intraday reversal in the dollar/euro exchange rate was the largest since 2009, and the combined drop in equities, bonds and the dollar has been described as the most severe since 1999.

Mr Draghi must have been concerned about this extreme market reaction, because his speech in New York the following day struck an entirely different tone. He attempted to upgrade the size of the new package of quantitative easing from €360 billion to €680 billion, and in effect promised unlimited QE until the inflation objective is reached (see John Authers).

Many investors have blamed Mr Draghi for some misleading forward guidance going into the Governing Council meeting. The announcement certainly fell some distance short of the pre-emptive easing that appeared to be in his mind less than one month ago, when he said that the ECB would use “all instruments” to return inflation to target “without undue delay”. Almost all professional ECB watchers were wrong-footed by the turn of events at the end of last week.

So which is the real Mr Draghi? And is he still in control? Read more

This is the latest report in our regular monthly series of “nowcasts” for global activity.

Global economic data published in November have shown a further uptick in worldwide activity growth after the significant dip that was reported after mid-year.

It now appears almost certain that the 2015 Q3 dip in world activity was not the precursor of a slide towards global recession. Instead, it seems to have been another of the minor mid-course corrections that have been a consistent feature of the moderate upswing in global activity that started in 2009.

Although the recent flow of data has therefore been somewhat reassuring about the global cycle, serious problems are still prevalent in the world economy. China has not suffered a hard landing; but severe deflation in the manufacturing sector remains unchecked, and the economy is clearly slowing as rebalancing between old and new sectors takes effect.

Most other emerging economies are now embarking on a major deleveraging cycle, and this may drag on EM growth rates for several more years. Growth in the advanced economies as a whole has been stable at about trend rates throughout 2015; but underlying productivity growth remains extremely weak by past standards. Therefore the advanced economies do not appear sufficiently robust to withstand an intensification of the EM shock, should that occur.

Overall, the global economy continues to grow below trend rates, so at some deep level the deflationary pressures in the system are not abating. However, the specific deflationary impetus from the commodity price collapse is now passing its maximum effect so recorded rates of headline and core inflation are likely to rise significantly in the next few months.

The latest data therefore confirm the conclusion reached in last month’s report: the global economy is suffering from a longstanding malaise but not from a cyclical recession. Full details of this month’s nowcasts and global industrial production data are attached hereRead more

Financial markets have been adjusting to the high likelihood of another aggressive round of unconventional monetary easing by the ECB on 3 December. This will complete a remarkable metamorphosis by a central bank that has traditionally been viewed as the most conservative in the developed economies, with the possible exception of the Swiss National Bank.

Mario Draghi’s official case for extra monetary easing is straightforward. Although the Eurozone economy has performed broadly as expected in recent months, the Governing Council has decided that “downside risks” to growth and inflation have increased, largely due to events in China. As a result, it may take longer to restore inflation to the target of “close to” 2 percent, and there is a greater danger of inflation expectations breaking lower in the meantime.

This may make sense, but there is little hard evidence that these risks are actually becoming reality. Activity growth in the Eurozone has recently increased to over 2 per cent, and core inflation is rising slightly. If the situation is bad today, it was even worse a few months ago. Read more

The new Chief Economist at the IMF, Maurice Obstfeld, posed a challenging question at the end of his first major policy conference in charge last week: “Is China the new Japan?” This question has been asked before, usually in the context of the massive credit bubbles in the two economies. The deflationary lessons from Japan’s imploding bubble in the 1990s are often thought to be relevant to China’s credit bubble in the 2010s, and this story is far from over.

Maurice Obstfeld, however, had something more specific in mind. He cited the work of the late Ronald McKinnon, a distinguished international economist who argued in the 1990s that Japan was being forced into deflation by an overvalued exchange rate. That, in turn, stemmed from the political pressure exerted on Japan to correct its current account surplus by raising the value of the yen. The implied threat, notably (but not solely) from the US Congress, was that direct trade controls would be imposed on Japanese exports if the exchange rate were “artificially” held down. Read more

The latest and, so far, the most severe scare about global deflation started with the oil price collapse in mid 2014, and reached its peak with the sharp drop in global industrial production in mid 2015, swiftly followed by the Chinese devaluation episode in August. Fears of an imminent slide towards a global industrial recession haunted the markets, and both expected inflation and bond yields in the advanced economies approached all-time lows.

But, just when everything seemed so bleak, the flow of economic information changed direction. Global industrial production rallied, and China stabilised its currency. On Friday, the US jobs and wages data were much stronger than expected. Inflation data in the advanced economies have passed their low points for this cycle, and the rise in headline 12-month inflation in the next three months could surprise the markets.

This certainly does not mean that the repeated warnings of the inflationistas will suddenly be proved right. It may not even mean that long-run deflationary pressures in the global economy have been fully overcome: global growth rates are still below trend, and spare capacity is rising in the emerging world. But the peak of the latest, commodity-induced deflation scare is in the past. Read more