US
The Federal Open Market Committee (FOMC) kept interest rates unchanged due to concerns about global weakness, especially in China, but left open the possibility of a modest policy tightening later this year.
In the Committee’s own words: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
The decision was not unanimous. Jeffrey M. Lacker from Richmond wanted to raise the target range for the interest rate by 25 basis points at this meeting.
The labour market situation is however still dominating the Fed’s thinking on inflation. In the press conference Yellen repeatedly stressed that “some further improvements” in the labour market will give the FOMC (Federal Open Market Committee) the necessary confidence that inflation will accelerate. Then, the time for lift-off (the first rate hike) would have come. It is worthwhile noting 13 of the 17 FOMC members continue to expect a first rate hike in 2015.
For 2015, two further FOMC meetings are scheduled: one on 27/28 October, the other on 15/16 December. What, then, is the more likely date to finally take the big (first rate hike since 2006) small step (plus 25 basis point)? On first glance, one argument against October is that no press conference is scheduled after that meeting. Market participants firmly expect that the Fed will want to explain such a significant event as the first rate hike in a press conference. Yellen tried to keep the option for October open. Every meeting would be “live” and the Fed could call a press briefing at short notice should they decide on lift-off in October. A more relevant argument against October is that only one employment report will be released before that meeting. Before the December meeting, the Fed will have three employment reports to ponder. This more comprehensive data set naturally will give a better view whether the labour market continues to improve as expected.
There is a school of thought which suggests the Fed must act aggressively. Their argument can be summarized a follows:
- First, the current blockages in Congress make a meaningful fiscal expansion in the face of much weaker growth unlikely.
- Second, as the economy slowed, FOMC members would not know whether a recession was unfolding until it was too late, so may be inclined to act on a precautionary principle.
- Third, as the economy slowed, markets might panic, forcing the Fed’s hand.
If the economy did slip back into recession, QE4 would initially look much like QE3: roughly $85 billion per month of Treasuries and mortgage-backed securities, open-ended until the Fed was confident that it was on track to meet its objectives. But would it be enough? There are many doubts.
QE boosts the economy indirectly, through wealth effects from rising asset prices and keeping short- and long-term real interest rates lower than they would otherwise be. It also relies on the transmission of policy through the banking system. Although policy should be more effective than it was after the financial crisis because the banking system is in better shape and private balance sheets are less impaired, QE may still not be enough to generate strong growth and prevent inflation from slowing dangerously. At that point even more unconventional policies would need to be considered and there are a number of options. The most effective, however, would be to launch helicopter drops of money, combined with a commitment to return inflation or nominal GDP to its previous trend.
EU
The Fed decision not to hike in September was to a large extent priced into US interest rates, but even so there was a strong reaction. Yields fell for all maturities. The two-year yield dropped 12 basis points. As a result, the dollar dropped immediately against major currencies. The euro surged from below 1.13 in European trading to close around 1.1440 Thursday evening. This is unwelcome news for the ECB. At the press conference following the September ECB meeting, Mario Draghi warned that risks for growth and inflation were on the downside. Following those comments, the EUR/USD dropped below 1.11, which was probably what he wanted.
As markets have now pushed back the timing of Fed rate hikes, Mario Draghi is left with difficult choices. This increases the likelihood of ECB action in October. At the latest meeting, the ECB opened up for additional measures to be taken should the outlook deteriorate.
It is likely the renewed euro strength will lead to downward revisions of ECB growth and inflation forecasts and as a result the ECB should act. The trade-weighted euro has gone up almost twice as much as the dollar since late July, so relatively speaking the ECB should have more reason to factor in the currency than the Fed has.
While further interest rate cuts are possible, the scale of available stimulus through this channel is clearly limited. There is more firepower left in the Asset Purchase Programme (APP). The central bank could materially increase the level of monthly purchases, include investment grade corporate bonds and make the program more explicitly open-ended. This would allow a significantly larger balance sheet expansion, which should weaken the euro, lower effective interest rates and boost inflation expectations – all of which should support spending and investment in the Eurozone.
While changing the scale of the APP would likely make it more powerful, there are circumstances in which it would not be sufficient. If the Eurozone were to be hit by a major growth shock, it would likely require more aggressive policy to keep inflation anchored. One option would be a widespread loosening in fiscal policy, ideally focused on infrastructure investment. This might be easier said than done.
Fiscal positions in many parts of the currency union remain fragile and would be significantly exacerbated by another downturn in growth. This could spark concerns over the solvency of some member states, although the ECB’s APP and the threat of Outright Monetary Transactions (OMT) would probably be sufficient to prevent spikes in bond yields.
There are escape clauses from the Fiscal Compact in the case of a severe economic downturn, although outright stimulus packages would be controversial in countries with high debt levels.
Earnings expectations for eurozone companies are likely to continue to be scaled back. The price pattern this year suggests the eurozone stock market is likely to underperform the US until the EUR/USD falls back again.
UK
Half a year ago people were puzzled that wage inflation in the UK was so low despite the fact that slack in the labour market had disappeared. This is no longer the case. Private sector wage growth in the UK has shot up from 2 percent in January to 3.4 percent in July.
The more economic recoveries progress, the more signs we see that things are not that different from previous recoveries. For example, there is no magic factor holding back wage inflation when labour markets start to overheat, as they are doing now in parts of Europe.
The very different speeds of recoveries across Europe have resulted in unusually large differences in the amounts of slack in labour markets. As measured by the gap between OECD estimates of NAIRU and actual unemployment rates, Germany is currently in overheated territory with a gap of +0.8 percent. The rest of the eurozone is still very far from full unemployment, with an unemployment gap close to -2.5 percent. Italy is lagging severely behind in the recovery with an unemployment gap of nearly -3.5 percent. The UK is rather similar to Germany and has crossed over into overheated territory with an unemployment gap of +0.6 percent.
These differences are now clearly reflected in wage trends. According to just-published Eurostat labour cost data for Q2, German wage inflation was 3.5 percent, just ahead of UK at 3.1 percent. More recent national statistics for these countries show a further acceleration in Q3.
The UK hit a six-year high on wage growth in July. For the Bank of England the clear pickup in wage inflation should be welcomed news. Core inflation in UK is still held back by the strength of the pound sterling, but domestic conditions for rising inflation are now clearly in place.
As per the cental bank policy, The Bank of England has not, as yet, been pushed off course by recent market volatility. While last week’s Monetary Policy Committee (MPC) minutes warned that risks in China and other emerging markets had increased, the overall tone was only moderately changed. Weale commented that the “Bank Rate will need to rise relatively soon,” while Forbes suggested that the stronger pound might weigh less on inflation than predicted by traditional BoE models. Both members look likely to join McCafferty in voting for a rate hike soon.
Overall, it is likely the Bank will raise rates in February next year, barring any further deterioration in global growth or a more pronounced feed through of financial stress to the domestic economy.
Under an alternative, more pessimistic scenario, the degree and speed of policy support would of course depend on how acute and long lasting any downturn would prove. The first policy steps to any sharp deterioration in activity are likely to be familiar. The Bank would use a combination of rate cuts, quantitative easing (QE) and forward guidance as a first line of defense against a slide back into recession. The previous floor of 0.5% on short-term rates would likely be breached, with other economies having successfully experimented with negative interest rates.
Furthermore, the Bank could generate more bang-for-its-buck by making QE explicitly open-ended, as opposed to its previous approach of announcing incremental tranches. Fiscal policy would be relaxed, although there would soon be an active debate about the need to generate a more powerful fiscal response. Chancellor Osborne’s newly penned fiscal rules do have a get-out clause, with borrowing permitted outside of “normal times”.
China
A weak Chinese demand presents the largest risk to growth over the medium term. China has responded to weaker than expected growth with numerous interest rate cuts and limited fiscal spending, yet as data continues to deteriorate it is unclear how the economic game plan will evolve.
Following weak August data, how Chinese policymakers should act if growth weakens substantially from here?
They have responded with limited stimulus measures so far, but nothing resembling past crises. Monetary easing has had some impact but, with credit demand extremely weak, it is unlikely to sufficiently boost growth. Additionally, a stimulus program similar to that used in 2009 is neither possible nor would it be impactful.
Following the collapse of Lehman Brothers, former Chinese president Hu Jintao was said to believe only state-owned enterprises (SOEs) could be trusted to support growth. As a result, state banks distributed nearly $600 billion to SOEs to fund infrastructure projects and massive increases in manufacturing capacity. In China’s current situation, those same SOEs are riddled with overcapacity and there are far fewer infrastructure projects that will offer a return on investment. Chinese SOEs largely exist in fading sectors and there are fewer opportunities for the government to directly fuel investment in faster-growing industries. Additionally, following the massive increase in private sector debt, a similar credit boost would only heighten the risks to China’s banking sector.
Simply put, China’s options are limited. Based on underwhelming SOE reform plans and increased chatter by the Ministry of Finance, it appears China is resorting to an old play from their well-worn playbook: increased stimulus for infrastructure investment. They are not pushing ahead on structural reforms that will remove barriers to private sector investment in dynamic industries, but instead will funnel money to trusted companies to boost growth in what they believe will be a dependable manner.
This all ignores a sizeable problem: infrastructure investment spending is already growing at record levels and has little room to increase. Growth is, and will, continue to fall. Due to investment dwindling across most other sectors, and that the private sector now accounts for roughly two-thirds of investment spending, the state has a diminished ability to significantly boost growth. This all makes the imperative of SOE reform, and a reduced role of the state in economic affairs, that much starker. With declining investment levels across most sectors, it is only a matter of time before wages, employment and thus consumption exhibit more strain.
It is unclear what policymakers have determined as their acceptable “floor” for growth, or how much labour market or consumer weakness they would tolerate before substantially increasing fiscal stimulus measures. What is clear, however, is that a response focused on infrastructure stimulus may marginally support growth in the short term – but as the impact shrinks, China will be out of options.
Sources: Commerzbank, Handelsbanken, Standard Life Investments
