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 .
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
The extraordinary volatility in all financial asset classes in the past week can only be described as ominous. On Wednesday, the US ten year treasury, perhaps the most liquid financial instrument in the world, traded at yields of 2.21 per cent and 1.86 per cent within a matter of hours. This type of volatility in the ultimate “risk free” asset has previously been seen only in 2008 and other extreme meltdowns, so it clearly cannot be swept under the carpet.
A few weeks ago, investors had widely expected a strengthening US economy to lead to a rising dollar and a tighter Federal Reserve, with an amazing 100 per cent of economists saying they were bearish about bonds in a Bloomberg survey in April. Instead the markets have started to act as if the world is about to topple into recession, and an abrupt reversal of speculative positions has probably led to exaggerated market moves, in both directions.
Now that excessively large positions have been washed out, what is the underlying message from the past month of market action? Read more
Financial markets caught a nasty chill last week, when extremely weak activity data from Germany coincided with fears that the ECB could not overcome Bundesbank opposition to more aggressive quantitative easing. Then the IMF reported that there is a 40 per cent probability of a recession in the euro area within 12 months, along with a 30 per cent chance of outright deflation. Markets fear that policy makers in the euro area are once again losing control over their weakening economy.
Since markets often sniff out impending trouble before economists do, there is, as Martin Wolf warns, no room whatever for complacency. But, so far, the blip in global risk assets hardly registers on the Richter scale. Nor is there much evidence from published data of a major slowdown in global GDP growth up to now.
US domestic demand is strengthening, and the 20 per cent fall in oil prices since June will boost the oil importing economies markedly in coming months. Unless euro area policy is spectacularly dysfunctional, which I do not expect, the slide in the euro area should not be powerful enough to offset these expansionary forces. Read more
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Last week’s press conference by ECB President Mario Draghi left the markets disappointed and somewhat perplexed about the shift towards quantitative easing that had just been sanctioned by the governing council (GC). Because this was focused on private sector assets, in the form of asset backed securities and covered bonds, there were doubts about whether the new policy could be implemented in sufficient size to deal with the deflationary threat in the euro area.
Mr Draghi was noticeably hesitant about giving any firm indication about the likely scale of the programme. Although private sector quantitative easing (QE) is likely to suit the needs of the euro area rather well, as I argued here, the absence of any firm guidance on scale certainly undermined the beneficial announcement effects of the policy change.
The ECB president addressed this issue on Thursday in an appearance at Brookings in Washington. This time, freed from the need to speak for the entire GC, he clearly changed his tune on the scale of the programme. But this highlighted the extent of the gap between his view and that of Bundesbank President Jens Weidmann, who presented his position in a revealing interview with the Wall Street Journal on Monday. It is far from obvious how this disagreement will be bridged. Read more
Tuesday’s extremely weak German industrial production figures published for August have come an awkward time for the German government. An informal “employment conference” including some EU leaders has been called by Italian Prime Minister Renzi, and it is scheduled to take place, amid little advance publicity, in Milan on Wednesday. This will presumably set the stage for the next European Council meeting on October23. In between will be the International Monetary Fund/World Bank annual meetings in Washington, when the German approach to economic policy in the euro area will be heavily scrutinised.
The official German line heading into these meetings is that the recovery is proceeding well, both in Germany and in the euro area as a whole, implying that the recent marked weakening in both gross domestic product and inflation data are just a temporary aberration. There is no sign that the Merkel administration is ready to change its longstanding formula for economic success in the eurozone: member states should stick to the fiscal targets in the Stability and Growth Pact, and should accelerate structural reforms, so that the expansionary monetary stance provided by the European Central Bank can bear fruit. Read more
The annual meetings of the IMF and World Bank will take place in Washington next week, with Christine Lagarde warning that the global economic recovery is “brittle, uneven and beset by risks”. Nowhere is this more true than in the euro area, where forecasts for GDP growth and inflation have both been revised progressively downwards, and where medium term inflation expectations are no longer consistent with the ECB’s inflation target.
ECB President Draghi’s remarkable speech at Jackson Hole in August seemed to offer a bold way forward, incorporating structural reform, fiscal easing and monetary expansion. Unfortunately, there have been few signs that political leaders are eager to co-operate with Mr Draghi on the first two of these three pillars, and even the third seems to have run into familiar obstacles on the ECB governing council. Read more
Much of the attention at the last policy meeting at the Federal Reserve was focused on the FOMC’s indication that interest rates would stay unchanged for a “considerable time”. But a more fundamental issue concerns another key phrase in the statement, which is the FOMC’s assertion that “there remains significant under-utilisation of labour resources” in the US. We are likely to find out more about this on Friday, when the US jobs data for September will tell us whether last month’s weak release was an aberration.
If there is still a large margin of slack in the labour market, despite tumbling unemployment figures, the Fed is unlikely to tighten monetary conditions very much in the next couple of years. Slack will also keep the wages share in national income low, thus boosting the profits share further. The utilisation of labour resources in America is thus critical not only for monetary policy, but also for the outlook for US equities.
The academic discipline of labour economics, which has not really been centre stage since the wage-push inflation of the 1970s, is therefore very much back in vogue. Empirical labour economists are needed to determine whether the decline in the official unemployment rate is providing the correct read on labour market slack and, if not, how to handle the problem.
This was the subject of a very timely conference at the Peterson Institute last week, which brought together many leading labour market academics, as well as key officials from the policy establishment in Washington and the wider Fed. The debate is available on the web, and is worth watching in full.
The overall message, which almost certainly reflects what the FOMC is being told by the academic and official economics community, was more dovish than I had expected.
Despite the fact that the official unemployment rate has fallen close to the Fed’s estimates of its “natural” or equilibrium rate, few empirical labour economists seem to believe, at least with any certainty, that labour resources are near full utilisation at present. Read more
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China’s economic rebalancing has been the main downside risk to global economic activity in 2014, and will probably remain so for the foreseeable future. The industrial production figures for August were the weakest seen since the 2008-09 recession, and they were followed by a statement from finance minister Lou Jiwei to the effect that there would be no change in economic policy “in response to one indicator”.
This echoed Premier Li Keqiang’s recent speech at the summer Davos meetings, which indicated broad satisfaction with the overall thrust of policy. “Just like an arrow shot, there will be no turning back”, he promised.
The possibility of a clash between a slowing economy and a Chinese administration that appears implacably set on a pre-determined course was not what the markets wanted to hear. Many western investors have long been predicting a hard landing for China, and do not need much persuasion to believe that it is finally at hand. But recent data do not suggest that it is happening yet. Read more
As the market awaits the Federal Reserve’s statements on Wednesday, the focus is on whether the FOMC will choose to signal a significant shift in a hawkish direction since its last meeting in July. Many investors believe that the key litmus test for this will be whether it chooses to drop two words from its July statement.
These words are “considerable time”. If that phrase disappears, then the market will need to absorb the fact that the Fed has deliberately chosen to force an upward adjustment in forward interest rate expectations, for the first time in this economic cycle. Read more