Since mid-February, the financial markets have become much less concerned about a hard landing in global economic activity, or at least about a potential clash between slowing economic activity and inappropriately tight macroeconomic policy from China and the US Federal Reserve. Financial conditions indicators have eased in the big economies, and this has been accompanied by a partial recovery in business surveys in many parts of the world.
In the last edition of our monthly report card on Fulcrum’s global nowcasts, we commented that economic activity had turned a corner in the US and China, but this was offset by continued weakness in several key economies, including Japan and the UK. A similar pattern is apparent in this month’s nowcasts. Global recession risks, which seemed elevated in January and February, have now receded, but the world economy is far from robust.
We therefore leave the overall verdict unchanged from last month: global activity growth is somewhat better, especially in the emerging economies, but it is still a long way from being satisfactory. (Full details of the latest nowcasts are shown here.)
Lord Jim O’Neill, formerly my colleague and chief economist at Goldman Sachs, has just delivered his maiden speech as the new commercial secretary at the UK Treasury. He said that one of the government’s “primary objectives is to deliver a step change in the nation’s productivity”. Even for him, this represents a tough challenge. After featuring barely at all in the recent election campaign, low productivity growth has rightly become public enemy No 1.
Falling productivity growth has been an increasingly serious problem for most advanced economies since the early 2000s, when the boost from IT seems to have run out of steam. But the problem has been particularly severe since the 2008 financial crash, and the collapse in the UK since then has been much greater than in other advanced economies.
Overall, UK productivity had fallen about 16 percentage points below its previous trends by 2014, about a quarter of which might be due to faulty measurement in the official data. If the UK government is to make any inroads into the problem, it first needs to solve the “puzzle” of why the rest of this huge shortfall has occurred. Read more
Ever since the crash in 2008, the central banks in the advanced economies have had but one obsession — how to set monetary policy to ensure the maximum growth rate in aggregate demand. Interest rates at the zero lower bound, followed by a massive increase in their balance sheets, was the answer they conjured up.
Now, those central banks contemplating an exit from these policies, primarily the US Federal Reserve and the Bank of England, are turning their attention to the supply side of their economies. When, they are asking, will output reach the ceiling imposed by the supply potential of the economy?
The Bank of England has been in the lead here, with the Monetary Policy Committee recently conducting a special study of the supply side in the UK. Its conclusion was that gross domestic product is now only 0.5 per cent below potential, which implies that tighter monetary policy will soon be needed if GDP growth remains above potential for much longer.
In the US, the Fed has been much less specific than that, but the unemployment rate has now fallen very close to its estimate of the natural rate (5.0-5.2 per cent). Sven Jari Stehn of Goldman Sachs has used the Fed staffers’ supply side models to calculate that their implied estimate of the US output gap may be only 0.6 per cent, not far from the UK figure.
If the UK and US central banks were to act on these calculations, the implication would be that they no longer hold out much hope that they can ever regain the loss in potential output that has occurred in the past decade, relative to previous trends. That would be a massive admission, with an enormous implied sacrifice in future output levels if they are wrong. It would also be very worrying for financial assets, since it would draw the market’s attention to a downgrade in the Fed’s estimation of the long-run path for GDP. Read more
The generally optimistic tone at Davos last week was rudely interrupted by a melt-down in emerging markets, triggered by concerns that the major central banks in the developed economies are contemplating an exit from easy money sooner than previously expected.
The Fed will probably take its second step towards tapering next Wednesday and now seems to be on auto-pilot for the rest of the year. More surprisingly, the Bank of Japan sounded some cautious notes about the likelihood of further quantitative easing when fiscal policy tightens in April. Finally, the UK authorities, in the shape of “aides of the Chancellor”, hinted that a rise in short rates may be no bad thing this year.
A significant shift towards tighter monetary policy in the developed world as a whole still seems extremely unlikely, given the deflation risks highlighted by the IMF last week.
But the British case is now very intriguing and, after contradictory messages at Davos, also somewhat confused.
Because of low productivity, the level of UK GDP continues to lag well behind the recovery from the Great Recession achieved in many other economies. But the remarkable recent surge in UK growth rates, along with a sharp fall in unemployment, means that the Bank of England now has to reconsider its entire monetary stance. With forward guidance now in murky waters, the markets will want greater clarity in the next Inflation Report in February. Read more
Mark Carney’s announcements today about the UK housing market represent the first blast from a major country of a new policy weapon that is increasingly available to the global central banks, a weapon known as macro prudential regulation. Because this weapon is seen as an alternative to raising short rates, not as a prelude to raising them, the Carney intervention should logically under-pin the lower-for-longer path for short rates discussed in his evidence to the Treasury Select Committee earlier this week. Mr Carney has turned more hawkish today, but not more hawkish about interest rates or sterling.
The Carney announcement will represent an important restraint on the UK housing market, which was showing distinct signs of getting too ebullient in the south east of the country. By acting early, and using methods that are distinct from the short term interest rate, this action may well make the economic recovery in the UK more durable than otherwise, though it may slow down some parts of the consumer sector in the immediate future. Read more
The new Funding for Lending Scheme (FLS) announced today in the UK is a useful and sensible development. It directly attacks the important micro problem of inadequate lending to small and medium sized enterprises (SMEs). But it is unlikely to have large scale macro-economic effects.
The FLS was introduced last July to address the increase in the funding costs which British banks were incurring as a result of spill-overs from the eurozone crisis. This had increased lending rates on UK mortgages and corporate loans at a time when the monetary policy committee was trying very hard to ease overall monetary conditions in the UK. And the FLS was the chancellor’s main response last year to the charge that he was deaf to the needs of the real economy, and inflexible in his pursuit of austerity policies.
Almost a year later, the verdict on the FLS is that it has significantly reduced banks’ funding costs, with the benefits of that being mostly passed on to mortgage and company borrowers, but that it has had relatively little effect on overall bank lending to companies, especially to small and medium sized enterprises (SMEs).
Today’s extension to the FLS greatly increases the incentive for banks to skew their lending to SMEs by offering them larger overall access to subsidised funding if they do that. Every pound of SME lending in 2013 will contribute tenfold to the banks’ eligible total of subsidised FLS lending. In 2014, it will contribute fivefold.
Furthermore, today’s announcement extends the FLS by 12 months to the start of 2015, thus re-assuring banks that their access to cheap funding for new lending will not suddenly disappear early next year. The Chancellor also hopes that the new FLS will help to influence the IMF’s response to his overall economic approach when they visit the UK shortly. Read more
Predictably, the chancellor has rejected calls for a radical change in his economic strategy. Plan A has not morphed into Plan B. If anything, it has become Plan A-plus, with the underlying path for fiscal tightening left unchanged, and a little more flexibility for the Bank of England to pursue unconventional monetary stimulus.
UK real GDP is still stuck some 5 per cent below its pre-crisis level, the worst record among the major economies, apart from Italy. Some of this is certainly due to the problems which the Coalition inherited. However, about half of the shortfall in UK growth in recent years, compared to that in the US, is due to the tightening of 5 per cent of GDP in fiscal policy since 2009/10.
The dominant criticism of the government from mainstream economists is, of course, that the poor performance of UK GDP is due to a shortfall in aggregate demand, which in turn is primarily due to these fiscal measures. The Chancellor’s reply is that the UK could have faced a fiscal crisis without his budgets. The fact that public debt is now forecast to rise to 85 per cent of GDP in 2017/18 suggests that his concerns are not easy to dismiss as scare-mongering. Read more
The sterling exchange rate has now declined by about 7 per cent this year, thus eliminating all of the rise which occurred when the euro crisis was in full flood in 2011-12. Investors are asking three main questions about the drop in sterling. When will it end? Will it succeed in boosting UK economic growth? And could it, conceivably, lead to a full blown sterling crisis? Read more