Economic Outlook – 19 October 2015


The decision as to whether interest rates should be hiked for the first time since 2006 will not be an easy task for the Fed, as data are not painting a clear picture. On the one hand, the headwinds from emerging markets are increasing, the dollar has appreciated markedly and the inflation rate is well below target. On the other hand, the domestic economy is robust and full employment has all but been achieved.

Hence, it does not really come as surprise that there are conflicting opinions among the leading policymakers. Normally, such differences are largely waged in public only by the twelve regional Fed presidents. But this time, the inner leadership circle comprised of the Federal Reserve Board, seems also to be deeply divided, as suggested by a speech by Lael Brainard, who joined the Federal Reserve Board in 2014. According to Brainard, the risks for the US economy are currently tilted to the downside, largely driven by “progressively gloomier projections of global demand”.

She argued that this is already weighing on financial markets, stating that the effect of a sharp increase in the dollar has been equivalent to a couple of rate hikes. Moreover, she raised serious doubts whether the improvement in the labour market is sufficient for the desired increase in inflation. Against this backdrop, she advised the Fed not to raise rates in 2015. Daniel Tarullo, another member of the Board, took the same view.

What makes these statements extraordinary is that both Chair of the Board Yellen and Vice Chair Fischer held speeches in recent weeks that placed them in the camp of officials who favour raising rates in 2015. Normally, the members of the central board (which by statute consists of seven of the twelve voting members on the Federal Open Market Committee) take a unanimous position which is determined by the Chair of the Federal Reserve Board. If the majority within the FOMC decided to hike rates at one of the two forthcoming meetings, two of the Board members might vote against Yellen, which would be extremely unusual.

One reason why the doves are going on the offensive seems to be that support for the hawks has been growing. Thus, the minutes of the Board’s last meeting show that eight of twelve regional Federal Reserve Banks in September argued in favour of hiking the discount rate. Apart from Yellen and Fischer, the President of the New York Fed, Dudley, also signalled that he stands ready to raise rates by year-end 2015.

Last but not least, the open conflict within the Fed is a struggle of economic ideologies, which essentially revolves around the Phillips curve, or the question as to whether there is a reasonably stable relation between capacity utilisation (as reflected by the unemployment rate, or more particularly the gap between the unemployment rate and the “natural” level of unemployment) and inflation. Hence, solid growth and the resultant increase in labour demand, whilst unemployment is declining, should sooner or later lead to higher wage increases and higher inflation rates. The majority in the FOMC believes this to be true, whereas the doves are calling it into question.

For Janet Yellen, the struggle goes beyond an intellectual debate over the validity of the Phillips curve. In fact, Brainard and Tarullo have publicly called into question the validity of Yellen’s views who only recently argued in a key speech that the Phillips curve is a reasonable instrument on which to base monetary policy, and which would signal a first rate hike in 2015.

If Yellen were to give in to the doves, she would seriously weaken the traditionally strong role of the Board Chair. The decision on the first rate increase has thus turned from an economic debate into a power issue. In our view, the balance of probabilities suggests that Yellen will go ahead with a first rate hike in December, in order to resolve the power issue. She and Vice Chair Fischer will likely try hard to reduce the number of three dissenting votes (besides Brainard and Tarullo, Evans from the Chicago Fed might dissent).

However, it would not be the first time that an important and controversial decision is pushed through in the face of opposition. This should be a price Yellen is willing to pay. Moreover, remaining on hold in December would provoke opposition from the hawks.

The public display of discord not only undermines Yellen’s position but also the Fed’s communications. Clear communication is after all an essential element of effective monetary policy. Public differences of opinion among leading Fed members, particularly if they reveal major divergence on the Board, only serve to obscure the Fed’s course of action. It is increasingly less apparent to observers just how the Fed responds to data.

So the Fed chairperson will have to take control of the reins very soon. The markets need a clear signal, and the Fed will have to decide between two options:

Either Yellen abandons her own position and backs the views of Brainard and Tarullo. It would then be clear that a rate hike is not imminent. It would also be clear that the Fed is taking more notice than previously of global economic influences. And finally, the financial markets would feel justified in their sceptical assessment of the scope available to the Fed in raising interest rates. The power struggle mentioned above makes this option unlikely.

Alternatively, Yellen will have to make it clear very soon that she wants to push through a rate hike before the end of the year. And she must do so unequivocally before the FOMC meeting in mid-December, since this is when a rate hike would most probably be approved. Otherwise, the shock of a rate hike would be too great, as market expectations increasingly believe that nothing will.

While the first move is likely to be prompted largely by power considerations, subsequent decisions should be based on economic data. It will then become clear whether the Phillips curve adherents are right. If so, a steeper rise in interest rates than the market is to be expected. Alternatively, the sceptics will be proved correct, and then the process of rate hikes would probably come to an early end.

What do the data say? One of the doves’ arguments is that the unemployment rate paints too rosy a picture. They claim that under-utilisation of labour market resources is greater than suggested by the unemployment rate, as many unemployed have given up looking for work owing to the limited prospects of finding a job. The evidence they put forward is the fall in the participation rate which dropped drastically during the 2008/ 9 crisis and has not since recovered. Despite a seemingly lower unemployment rate, the doves claim that this ‘reserve army’ is hindering more substantial pay rises and thus rising inflation.

This argument is not convincing after five and a half years of steady job growth. Payroll growth has remained robust at around 2% p.a. and should long have tempted potential workers from the reserve pool back onto the labour market. This has not happened, though, and the participation rate has not recovered which is a strong indication that this ‘reserve army’ simply does not exist and the decline in participation is due mainly to demographic change in an aging society and longer-term changes in employment practices, i.e. it has little to do with the business cycle.

This is also in line with the observation that the number of job openings this summer, at 5.75 million, was the highest since these statistics were first recorded in 2000. Employers are evidently finding it difficult to fill vacancies quickly. Arithmetically, there are currently 0.7 jobs available for every unemployed person. In earlier years, similar levels were accompanied by accelerating wage growth. Sooner or later, employers will also have to compete for staff in this economic cycle by offering higher wages. Since the low point of the crisis which resulted in annual wage growth of roughly 1½%, wage pressure has already increased a little.

The latest data available, for the second quarter of this year, show wage growth of 2.1% measured by the employment cost index. Overall Yellen and Fischer’s view, suggesting that this trend will continue, is more realistic than the doves’ standpoint which suggests that wage growth will remain very low.

Even if the forthcoming process of rate hikes proves very flat by past standards, the expectation is the Fed to act more aggressively on rate hikes than the market currently envisages. However, the Fed’s first move will probably not be enough to convince the market to rethink its viewpoint.

Market players have after all been right so far in their skepticism regarding the scope available to the Fed for raising rates. Over the course of recent years, FOMC members have lowered their estimate of the ‘natural’ unemployment rate a number of times, thus raising the threshold above which inflationary pressure sets in. And the dots, i.e. the FOMC members’ estimate of an appropriate interest rate course, have drifted downwards. In other words, the FOMC has so far moved closer to the market view rather than the other way around. So the Fed will probably have to make a second and third interest rate move before the market comes to terms with a steeper interest rate course.

A return to normal interest rate policy may seems appropriate, given the robust domestic economy and an unbroken healthy labour market. Our interest rate forecast is close to the FOMC average (which is 1.4% for the end of 2016 and 2.6% for the end of 2017). The power struggle at the Fed is, however, clearly a threat to our forecast; once Yellen has cemented her position by pushing through initial rate hikes, she could shift to a compromise in order to calm things down and yield some ground to the doves. Yet this does not alter the fact that in our view the market is currently pricing in too few rate hikes.


In the past few weeks, a number of ECB governing council members have signalled that the waiting stance will be maintained. This included members who appear open to further measures (Linde, Vasiliauskas, Jazbec). The detailed comments of Erkki Liikanens are particularly interesting as he is very much against deviating from the ECB’s official line. Last week, he compared the central bank’s current purchase programme to a marathon: “we are only at kilometre 15 … And if things change we should not draw any hasty conclusions”. He then added, “if you speculate too early about doing more, it also weakens what you have already decided on. I hope it will be enough to buy until September 2016”.

The data situation also suggests adhering to a wait-and-see stance for now. After the last council meeting, GDP data for the Eurozone was significantly revised to the upside. Furthermore, the Eurozone economic indicators, published since the last council meeting at the beginning of September, actually came in better than expected on balance. The unexpectedly robust unbroken trend suggests that ECB projections should be awaited before new decisions are made and these will be available to the ECB governing council at the meeting in early December.

According to the recently published minutes of the last governing council meeting in early September, the ECB governing council for the first time explicitly shared our long-held view that the correlation between oil prices and market-based inflation expectations had “significantly weakened” in the past eighteen months. This could be seen as a sign for less anchored expectations. The five-year forward inflation-swap-based expectation for inflation five years ahead (“5×5-expectation”) has now fallen, and at 1.60% is only just above the all-time low in January. Concerns in the ECB governing council should increase if survey based inflation expectations also point in the same direction.

The governing council should have the latest results of the ECB’s Survey of Professional Forecasters (SPF) at the meeting, although the data will probably only be officially released a day later. In the last survey, the SPF suggested that the likelihood of the ECB falling short of its target in the long term had risen somewhat. Should it climb further and the 5×5 expectation not rise again, this would support our expectation that the ECB will decide to increase the volume of asset purchases in December.

In terms of data releases, the PMI figures due for release on Friday will also be watched closely by market participants. So far, the euro-area manufacturing PMI has remained broadly unaffected by the weakness in emerging markets, even though there has been a couple of months with falling financial sentiment indicators (Sentix and ZEW). In line with the financial sentiment a decline in the manufacturing PMI is likely, and this would also be consistent with the lower order-inventory balance and the recent weak German data.

Regarding the decline, regional differences are to be expected, with the German PMIs decreasing the most as the Volkswagen exhaust scandal is likely to add to the negative sentiment. At the other end of the range, the French PMIs should be less negatively affected as suggested by the recent improvement in French business surveys.

Data for the euro-area consumer confidence will also be released next week and in line with the weaker economic sentiment, consumer confidence is likely to decline. The inflation expectations in the Survey of Professional Forecasters are released Friday after the ECB meeting and should not have a large market impact, although a decline in the longer-term inflation is to be expected.


It was Winston Churchill who first claimed that the UK and US have a special relationship on account of their close political, cultural, economic and military ties. Many have argued that this relationship is dwindling, particularly in the wake of the unpopular Iraq-Afghanistan wars. From a trade perspective, the relationship is close – but not necessarily that special.

Measuring trade in terms of value-added confirms the US as the largest single export destination for UK companies, with 18% of exports heading across the Atlantic. However, other European Union countries account for more than double this share (41.5%), with the UK much more closely integrated into the EU. Indeed, this pattern is replicated when looking at foreign direct investment flows into the UK, with flows from EU countries close to double that from the US.

Furthermore, the relationship is more special from a UK perspective than that of the US – as has probably often been the case. The UK accounts for 5% of US exports measured in value added terms, lower than Canada, Japan, Mexico, the rest of the EU and China.

Against this backdrop, there are plans to strengthen trade links with the US through a Transatlantic Trade and Investment Partnership (TTIP) as part of a broader European initiative. Tariffs between the US and UK are already very low, estimated at 0.5% of the value of exports. The thrust of any agreement will centre on non-tariff barriers such as regulation and standards which are significantly larger at 8.5% of UK exports to the US. The Centre for Economic Policy Research has estimated the impact of an ambitious TTIP agreement, which eliminates all tariffs and removes 25% of all non-tariff barriers. This study finds that UK GDP would be a modest 0.3% higher under this scenario by 2027.

From a sectoral perspective, there are some clear winners and losers. Output in the primary sectors is largely unaffected, while services activity rises modestly. The financial service sector is the exception to this, enjoying a 1% increase in output over the model projection, reflecting the high levels of non-tariff barriers in the sector. The largest boost comes to manufacturing and is most pronounced in autos (+4%) and electrical equipment (+1%), while metals and other metal products output falls 1.5%.

It should be emphasised that the aggregate benefits for the UK of a TTIP agreement are smaller than those projected for the broader EU, which is expected to see its GDP rise by 0.5% over the same period. This reflects different levels of openness between the US and UK, and the US and EU respectively. Furthermore, it also accounts for some trade diversion, with the EU expected to benefit more from liberalisation.

Objections to the TTIP in the UK have mirrored those in the broader EU. There is concern over the erosion of EU standards, particularly around the food and beverage sector. Furthermore, the prospect of investor-state dispute settlements have caused an outcry, although the government insists that these are contained in existing bilateral agreements and it has never lost a case. The UK has an additional homegrown concern in terms of the NHS.

There are fears that a TTIP could infringe on the government’s ability to keep health providers in the public sector, or reverse previous privatisations. EU and US negotiators have released a statement saying that “US and EU trade agreements do not prevent governments…from providing or supporting services”. The final wording of any TTIP agreement will have to be clearer to prevent any ambiguity around these issues.

British inflation unexpectedly edged back into negative territory in September to match April’s record low, after cheaper fuel and clothing (smaller than the usual rise) pushed down the average. Core inflation, which strips out volatile components like food and energy, also remained weak at 1.0%.

Unlike policymakers in the Eurozone, the Bank of England seems relatively unconcerned about the risk of persistent price falls leading to deflation, due to robust consumer demand and rising domestic wages. However, it will definitely not encourage the Bank of England to raise rates for some time to come.

The numbers will, in turn, have additional low inflationary effects on the UK economy, as the annual counting up of some benefits, public sector pensions and the state second pension is linked to the September CPI rate. Millions of Britons are unlikely to see any rise in these benefits. The same goes for most working age benefits, which are part of a freeze announced previously by the government.

The calendar is rather thin: the most important release is the retail sales data for September. This is the last release before the release of the first estimate of GDP growth in Q3. The retail sales is likely to rebound in September after sales disappointed both in July and August. That said, the outlook remains positive for private consumption going forward as it is supported by increasing employment, positive real wage growth, high consumer confidence, rising house prices and low interest rates.

Emerging Markets

GDP for Q3 is expected to show an increase of 1.5% quarter-on-quarter taking the year-on-year growth rate down to 6.7% from 7.0% in Q2. Note, though, that the quality of the data is quite poor and thus hard to forecast. The Chinese growth is likely to remain steady in Q3 and gradually improve in Q4 and Q1 as the housing market has turned and stimulus measures are expected to feed through gradually.

The decline in China car sales in the first half of 2015 was much more dramatic than the picture painted by the year-on-year numbers typically reported in the media and by analysts. A decline of around four million cars (seasonally-adjusted annual rate) is equivalent to more than a full year of German car sales, for instance, and is about one third of one year’s worth of EU car sales. As China has not only been the biggest car market in the world but also one of the most lucrative car markets in terms of profit margins, this decline took a hefty chunk out of global car makers’ profits in Q1 and Q2.

The good news is that sales turned around in August, with around one million more cars sold, while September saw about a million more cars sold. This year’s sales decline is thus reduced by half, though it is still substantial.

On October 1, policymakers in China cut the purchase tax on small (up to 1.6-litre) cars from 10 to 5 percent. That car category accounts for 68 percent of total sales in China. This is likely to give an additional boost to car sales in the current quarter.

Gradually, the relatively strong bounce in China car sales is likely to feed through to car manufacturer profits, even though margins have been squeezed this year due to the extreme weakness in demand. The recovery of car sales in August and September is perhaps a sign that the slumping stock market may only have temporarily affected demand for more expensive consumer capital goods, and may also be a sign that the underlying strength of consumption demand is quite strong.


Sources: Commerzbank, Standard Life Investments, Danske Bank, Handelsbanken.