Macroeconomics

Mario Draghi

  © Hannelore Foerster/Getty Images

And then there were none. On Thursday, the European Central Bank became the last of the major central banks to announce a large programme of quantitative easing, involving the purchase of over €1tn of assets, mostly eurozone government bonds, in the next 18 months.

Is this the “credible regime change” which economists like Paul Krugman say is the only way that central banks can affect growth and inflation when interest rates have reached the zero lower bound? It would be too optimistic to say “yes”, but it is certainly a major philosophical shift by the conservative standards of the ECB. Originally designed slavishly on the Bundesbank model, the ECB has declared independence from its German forebears today.

But the long delays in reaching this point have made the eurozone deflation threat more severe than it need have been. Whether this belated recognition of reality is a case of better late than never, or too little too late, remains to be seen.

The markets are likely to assess the package with three litmus tests: is it big enough, are the restrictions placed on the bond purchases too restrictive, and does it matter that the decisions were far from unanimous, with the Bundesbank probably opposed to some key elements? In my view, the good clearly outweighs the bad. Read more

The completely unexpected decision of the Swiss National Bank (SNB) to remove the 1.20 floor on the Swiss franc against the euro on Thursday was one of the biggest currency shocks since the collapse of the Bretton Woods system in 1971. The decision has been heavily criticised, both for its tactical handling of the foreign exchange market, and for the collapse of the centrepiece of its monetary strategy, without (apparently) any overriding cause. The credibility of a central bank that has traditionally been hugely respected by the markets has clearly been dented.

The decision has already caused severe stress and bankruptcies in the currency market, and it is far too early to judge whether this has now settled down. More importantly, the deflationary shock to the Swiss economy will be severe. And there are concerns that the failure of the SNB’s policy of unlimited market intervention may have much more profound implications for the credibility of the wider market interventions by global central banks, on which asset prices currently depend.

It is important to keep this in perspective. The SNB decision may have been driven to a large degree by the fear of losses on the central bank’s balance sheet, which are peculiar to the ownership structure of the central bank in Switzerland. Furthermore, other major central banks are not operating currency pegs, where large balance sheet losses tend to occur. Even so, this event will clearly make investors question whether the central banks can indefinitely exert as much control over the financial markets as the period of quantitative easing has suggested. Read more

T
he oil price has fallen by more than half in a little over six months, and you might expect investors to be cheering. Perhaps they would have been — had the result not been a precipitous drop in inflation.

A flight to the safety of government bonds has caused yields to fall lower than they have been at any time other than the darkest days of the euro crises of 2012. Although stock markets are still only 3.5 per cent from their all time highs, they have become a lot choppier. Prices are bouncing up and down, suggesting investors have become more nervous about the prospects for economic growth. Read more

The Brent oil price has fallen by a further 9.3 per cent in the first few days of 2015, making the total decline since mid 2014 a remarkable 56 per cent. With Saudi Arabia showing very little sign of restricting supply, economists have been scrambling to reduce their global inflation forecasts in line with the new reality in the oil market.

For investors and central bankers, two questions are dominating discussion – how much deflation will be seen in 2015, and how severe a threat does it pose to the health of the global economy? The answers are complex, because deflation is occurring simultaneously in two different varieties.

The first is “good” deflation, stemming from the huge beneficial supply shock from oil. But the second is “bad” deflation, stemming from a persistent shortage of aggregate demand in the developed economies, especially the eurozone.

At present, good deflation is definitely dominating the global picture, and this is being priced into asset markets. But the threat from bad deflation in the eurozone is still rumbling away in the background. Read more

The giant Euro symbol stands illuminated outside the headquarters of the European Central Bank (ECB) on November 5, 2012 in Frankfurt, Germany (Photo by Hannelore Foerster/Getty Images)

  © Hannelore Foerster/Getty Images

The markets are waking up to the fact that the euro area faces a critical few weeks in which its economic path for 2015, and maybe for much longer, will be largely determined. Three inextricably linked events will dominate the economic landscape in January: the preliminary opinion of the Advocate General of the European Court of Justice (ECJ) on the legality of central bank bond purchases, due on January 14; the decision of the European Central Bank’s governing council on the size and type of “sovereign” quantitative easing (QE), due on January 22; and the Greek election on January 25.

At the optimistic end of the spectrum, the euro area might emerge with a more complete monetary framework that for the first time enables it to pursue monetary policy effectively at the zero lower bound for interest rates, and with the sanctity of the currency area reinforced. At the pessimistic end, the ECB could become shackled with an ineffective version of QE just when the euro area is officially entering outright deflation, and the single currency itself might become incompatible with political realities in Greece.

The outcome will also have much wider global implications. The markets have remained relatively relaxed about the likely exit of the Federal Reserve from its own zero interest rate policy in 2015, but only because the ECB and Bank of Japan are injecting more monetary stimulus. If large scale ECB action is removed from this equation, sentiment on global risk assets may darken considerably. Read more

After several years in which inadequate demand has seriously constrained activity in the global economy, causing repeated downgrades to growth forecasts, 2015 should see an improvement. Lower oil prices and a more demand friendly fiscal/monetary policy mix should result in faster growth in aggregate demand. And the depressing weakness in aggregate supply, which shows no sign of any improvement, is not yet a binding constraint on global growth. This will be a year in which excess capacity in the global economy will start to be absorbed. Read more

In macroeconomics, this has indisputably been the year of Thomas Piketty. Rarely, if ever, has a single book so profoundly influenced the public discourse on a central topic, the inequality of wealth and income in the developed economies over many centuries. In an age of tweets and sound bites, the fact that a Herculean intellectual work can have such influence is surely uplifting [1].

The financial markets, however, have largely ignored the book, seeing it as outside the realm of their direct interests. This is a mistake since, whatever one might think of Prof Piketty’s policy recommendations, he has written a major treatise on the economic process that generates wealth in our societies, and that is exactly what most investors are trying to understand.

On Friday last week I was on a platform with Prof Piketty at the London Business School, and the slides from my presentation are downloadable here. The LBS does not plan to upload the video of the presentations on the web until early next year, so this blog contains my main points.

Parts of this are inevitably a bit technical. Skip to the final section for the bottom line. Much of this is still very controversial; debate is welcome.

 Read more

The financial markets saw only bad news in the oil shock last week. Despite extremely strong US consumer data, there is a reluctance to recognise the shock for what it is – a long-lasting structural change, with mostly beneficial consequences for aggregate demand in the developed economies.

As John Authers explains, weak Chinese data are causing concern, but there is little evidence that China has been the main cause of falling oil prices. Global oil demand has been fairly stable as supply has surged, and it is surely revealing that the latest oil price drop followed the Saudi decision to maintain oil output after the November OPEC meeting.

Like investors, economists have been thrown into confusion. Almost no-one in the profession (including myself) predicted the oil price collapse in advance. After the shock, it took months for oil price forecasts to be brought into line with the new reality. Futures prices in the oil market have performed no better: predicting oil prices can be a mug’s game.

More surprisingly, there has also been a disinclination to accept the potential benefits in the oil shock. Some economists have said it largely reflects an adverse demand shock in the global economy, so it is axiomatically bad news. Others have said that, even if it is a supply shock in the oil market, which would normally be beneficial, this time will be different, because it will be deflationary, and will therefore raise real interest rates.

There are some honourable exceptions, like Martin Wolf and David Wessel who have viewed it mainly as a supply shock with net beneficial consequences. But the pessimists have thrown up a lot of noise, reminding me of Professor Deirdre McCloskey’s maxim:

Pessimism sells. For reasons I have never understood, people like to hear that the world is going to hell, and become huffy and scornful when some idiotic optimist intrudes on their pleasure.

If the pessimists have a case, it is in oil producers in the emerging world, especially Russia. But, among oil importers in the developed world, it is hard to see too much of a dark side. Read more

One of the most successful rules for investors in the past few years has been never to underestimate the innate dovishness of the Federal Reserve. Whenever there has been a scare that the Fed might move in a hawkish direction, this has quickly proven to be a mistake. Forward curves for short term interest rates have consistently moved “lower for longer”, and incoming economic data have always ensured that the Federal Open Market Committee (FOMC) has remained comfortable with this tendency.

In recent months, however, the markets may have become over confident about the Fed’s dovishness in the face of a large and persistent decline in the US unemployment rate. The forward interest rates now priced into the bond market are much lower than the FOMC’s “dots” chart, which shows the interest rate expectations of individual FOMC members. Even after the market’s upward adjustment in rates following Friday’s strong labour market data, that remains the case.

The “dots” will be updated at the next FOMC meeting on 16/17 December, and it is unlikely they will be revised downwards towards the market’s view. “Normalisation” is the new buzzword. Fed Vice Chairman Stanley Fischer made it clear in an interview with Jon Hilsenrath of the Wall Street Journal last week that he believes that interest rates are far below normal, even if inflation stays low. A further upward adjustment in market rates may become necessary soon, unless inflation greatly surprises the Fed on the downside. Read more

The FT’s Martin Wolf has said almost everything that needs to be said about the global economic effects of the 2014 oil shock, but one additional point is worth emphasising. This is the fact that the US Federal Reserve and the European Central Bank view the consequences of the oil shock entirely differently. The markets have, of course, already been acting on this assumption, but the extent of the gulf between the world’s two leading central banks on this issue has been underlined by Mario Draghi’s dovish speech last month, and particularly by the Fed vice-chairman Stanley Fischer in a somewhat hawkish interview with The Wall Street Journal.

In perhaps his most significant statement since becoming vice-chairman in May, Mr Fischer made it clear that the period of low inflation due to falling oil prices will not deter the Fed from starting to raise interest rates next year. Furthermore, he suggested that the Fed might soon drop the assurance that it would not raise rates for a “considerable time”, replacing it with alternative language that is less constraining on its future actions.

It now seems likely that this language change could happen at the next Federal Open Market Committee meeting on December 16 and 17. By contrast, Mr Draghi and his supporters at the ECB clearly view the oil shock as a reason to shift policy in a more expansionary direction – if not at Thursday’s policy meeting, then sometime fairly soon. Read more

UK Chancellor George Osborne’s Autumn Statement next Wednesday will re-affirm his intention to embark on the second half of the fiscal consolidation that he started in 2010. The pause in fiscal tightening from 2012-14 will end immediately after polling day.

The Chancellor will promise large cuts in public spending relative to GDP, resulting in a budgetary tightening of over 5 per cent of GDP between 2014/15 and 2018/19. As a result of shortfalls in income tax receipts this year, spending restraint may need to last even longer into the next Parliament than previously expected. Read more

The simmering row between the European Central Bank president Mario Draghi and the German Bundesbank president Jens Weidmann is sometimes painted in personal terms, but in fact it epitomises a wider difference between the hawks and the doves on the ECB governing council. It is important to understand the anatomy of this dispute as the central bank prepares for its next critical meeting on December 4.

The dispute is fundamental and longstanding. Mr Draghi has adopted the New Keynesian approach that dominates US academia and central banking. There is really no difference between the philosophy that underpins his latest speech and that of Ben Bernanke, vintage 2011-13. In contrast, recent remarks by representative hawks such as Mr Weidmann and ECB executive board member Yves Mersch stem directly from the Austrian school of European economics. It is no wonder that these differences are so difficult to bridge. Read more

Dissatisfaction abounds in policy circles and among respected economic commentators (like Martin Wolf and Paul Krugman) about the weak and patchy recovery in global GDP which has been underway since 2009. Rightly so. At minimum, Japan and the euro area seem to be mired in secular stagnation.

Yet the financial markets do not seem to share this global pessimism. Although there was a brief growth scare in the equity markets in October, this vanished almost immediately, and markets are again in optimistic mode.

Are the markets living in a parallel universe, or are they smelling a near term improvement in global GDP growth? Read more

This blog has been updated to incorporate the Japan GDP data published on Monday.

Japan, it seems, is still stuck between a rock and a hard place. The rather shocking gross domestic product figures just published for the third quarter show that the economy has fallen into yet another technical recession since the sales tax was increased in April. On this evidence, it will be hard to achieve fiscal sustainability without abandoning the economic recovery. Abenomics, which was supposed to resolve this longstanding dilemma, is in trouble.

Although Japanese GDP data are notoriously volatile from quarter to quarter, and this batch was depressed by a temporary burst of inventory shedding, underlying consumer and corporate spending is very weak. Aggressive monetary easing and a huge devaluation have not been enough, as yet anyway, to overcome the effects of even a modest fiscal tightening.

In the next few days, Prime Minister Shinzo Abe is widely expected to react to the GDP figures by announcing that the second leg of a sales tax increase, scheduled for October 2015, has been postponed until 2017. Since this delay would be supported by two-thirds of the Japanese electorate, it may be the prelude to a snap general election in December.

In itself, the postponement of the sales tax increase will have a negligible effect on fiscal sustainability, and it will help restore the economic recovery next year. But the fact that it needs to be considered at all raises wider questions about the longer term success of Abenomics. Read more

The most significant economic shock in the global economy so far in 2014 has been the drop of more than 25 per cent in spot oil prices since the end of June. Since this shock is attributed by most energy analysts to an increase in oil supply, and not to a decline in global oil demand, this should have led to a significant decline in near-term world inflation forecasts, and to upgrades in global economic growth forecasts.

The disinflationary effects are uncontroversial. Lower oil prices have obvious direct and indirect effects on consumer prices. But the boost to growth is more debatable, since lower oil prices involve a redistribution of income from oil producers to oil consumers. Why should this reallocation of resources lead to a rise in real gross domestic product? Read more

The rebound in global equities since mid October once again leaves markets in nosebleed territory. The likelihood of an imminent sell-off depends on the economic cycle, the central banks, and temporary extremes in valuation. All of these factors are the staple diet of this blog.

But today I would like to reflect on whether we can expect the much longer up-trend in risk assets, which started in the early 1980s, to continue into future cycles. (Warning: some of this is a bit technical; skip to the end for the bottom line for investors.) Read more

Amid all the obituary notices for quantitative easing that were published when the Federal Reserve stopped buying bonds last Wednesday, it was temporarily forgotten that there are other central banks in the world moving in precisely the opposite direction.

The Bank of Japan immediately stepped up to the plate with an announcement of first order global importance on Friday. It shocked the markets with a gigantic increase in its QE activities, ensuring that the total central bank injection of liquidity into the global economy in 2015 will be much larger than it has been in the last year. Read more

The examination is over. For more than a year the European Central Bank has been shining a light on the books of the eurozone’s banks; this weekend it reported its conclusions.

The balance sheets of 25 institutions were found wanting; the ECB concluded that they need an extra €25bn between them to be able to withstand a nasty economic surprise. Two crucial questions remain. Has enough at last been done to fix the European banking system? And will this on its own be enough to ward off the threat of deflation that is hanging over the eurozone? Read more

In the years after the Great Recession of 2008-09, forecasts for global economic growth have persistently proven too high. This tendency has been particularly pronounced in the major emerging economies, where there has been a gradual realisation that long term trend growth potential should be revised downwards (see this blog).

In the developed economies, growth expectations have also proven persistently too high, causing an increasing focus on “secular stagnation”.

Three of my colleagues at Fulcrum have been examining the behaviour of long run GDP growth in the advanced economies, using developments of dynamic factor models to produce real time estimates of long run GDP growth rates. See the summary paper here by Juan Antolin-Diaz, Thomas Drechsel and Ivan Petrella, and the more academic version here [1].

The results (Graph 1) show an extremely persistent slowdown in long run growth rates since the 1970s, not a sudden decline after 2008. This looks more persistent for the G7 as a whole than it does for individual countries, where there is more variation in the pattern through time.

Averaged across the G7, the slowdown can be traced to trend declines in both population growth and (especially) labour productivity growth, which together have resulted in a halving in long run GDP growth from over 4 per cent in 1970 to 2 per cent now.

Some version of secular stagnation does seem to be taking hold. This may partly explain why, for the last five years, forecasts of G7 real GDP growth have been persistently biased upwards. Read more

Shenzhen Business District  © Nikada / Getty Images

It is very striking that western commentators and investors have become extremely sceptical about any good news emanating from the Chinese economy. This week, for example, official economic data showed growth in gross domestic product at a quarterly annualised rate of about 8 per cent, with industrial production bouncing back in September from a weak reading in August. Yet markets were unimpressed.

Although this latest news clearly reduced the danger that China is entering a hard landing as the property sector adjusts sharply, many headlines proclaimed, correctly, that the economy is now growing at the slowest pace since the last recession. So is China bouncing back from a weak patch of growth, or is it headed for a prolonged slowdown lasting many years?

Actually, both are probably true. Cyclical fluctuations are occurring around a clearly slowing long-term trend for growth, and this can defy simple good news/bad news interpretations. At present, it seems that the latest cyclical slowdown is being controlled, despite the property crash. Read more