Applying the monetary brakes

Published: Oct 2014

The projections for the coming years suggest that growth will be low around the world. In industrialised countries, this points to growth near 2%. In China, growth should hover around 7.5%. From a Western perspective, such a percentage seems almost unattainable, whereas the authorities in Beijing think that if growth were to decline any further, social unrest would ensue. Moreover, this rate is substantially below what the Chinese have been used to in recent decades. Something similar applies to many other emerging economies.

Deflation threatens

At first glance, these conditions do not seem conducive to rising interest rates. Quite the opposite; sluggish growth will likely put downward pressure on wages and inflation. It could even lead to deflation. As debts are sky high, that is a risk these economies cannot afford to take as the result could be a downward deflationary spiral. The way to counter this is through ultra-loose monetary policy and persistently low interest rates. If this is a realistic scenario, the financial market trends of the past years will continue. That is to say: stock market rallies, downward pressure on long-dated government bond yields, and narrowing credit spreads.

It would also point to relatively low volatility in the currency market as most countries appear to be ‘in the same boat’. However, we do not think this analysis is valid, most of all because the reason for weak growth varies among the different countries. In some, demand is stagnating and elsewhere supply threatens to falter. This has a very different impact on market rates and prices.

Chart 1: Monetary policy has been driving stock market performance since 2009
Chart 1: Monetary policy has been driving stock market performance since 2009

Source: Thomson Reuters Datastream/ECR

During the credit crisis, lending froze, income declined and deleveraging took place in the US as well as in many other countries. Overcapacity meant that deflation risks were high. At the same time, preventing deflation was the top priority for the US authorities. Ironically, they could only achieve this by accumulating more debt. To this end, the budget deficit widened. Simultaneously, the Fed lowered interest rates and launched a massive bond-buying programme to create more money. Eventually, asset prices rallied, especially property and share prices. This pushed up asset values in the private and business sectors. While the level of indebtedness continued to be high, it was at least offset by more valuable collateral. In turn, this facilitated new borrowing.

Tipping point

However, the higher debt (taken out following the credit crisis) was viewed as a temporary emergency measure to prevent deflation. In the slightly longer term, the idea was always to boost growth until full employment was achieved and (real) wage increases went up. The moment when real wage increases start to rise is crucial to the economy – a genuine tipping point. Generally, this happens in the case of (almost) full employment.

It is no secret that Fed chairwoman Yellen believes full employment is still some way off in the US. Although the jobless rate has dropped from over 10% to around 6%, she thinks there is a lot of hidden unemployment. In addition, a further fall in unemployment is unlikely to happen any time soon. At first glance, this suggests that it will be possible for the Fed to boost the economy for some time to come – and to postpone its rate hikes. However, many economists (including those who are close to Ms Yellen) are beginning to question the wisdom of such a course of action:

  • Studies indicate that there is a significant mismatch between what businesses expect of their employees and what job applicants have to offer in terms of skills and/or education.
  • Demographic trends suggest the decline in the participation rate (the percentage of people of working age available for the labour market) will decline further. Fed research suggests in 2016 just 45,000 additional workers will enter the labour market each month. To put this in perspective: this year, on average 200,000 new jobs have been created on a monthly basis.

The European approach

The surprise ECB rate cut and announcement to buy up various bank loans in early September differs from the actions of the Fed. The latter has focused on purchasing bonds, as most US credit is supplied via the capital market, whereas in Europe almost all of it comes from the banks. It seems an effective way to boost credit. After all, one of the main reasons why growth is sluggish in Europe is that the banks are reluctant to lend; specifically in the weak Eurozone countries.

Chart 2: Unemployment that includes involuntary part-time and discouraged job seekers remains high
Chart 2: Unemployment that includes involuntary part-time and discouraged job seekers remains high

Source: Thomson Reuters Datastream/ECR

Many economists fear that regardless of interventions by the ECB, economic growth will remain low in the EMU. They point out that the demand for credit is sluggish in both the business and the private sectors. Based on this, they assume that – eventually – the central bank will have no choice but to purchase government bonds on a large scale. However, some European governments are strongly opposing such large-scale quantitative easing as happened in the US:

  • They want to avoid growth fuelled by credit that could lead to another crisis.
  • Germany and the ECB in particular want more structural reforms to increase the added-value per worker to generate growth. They worry that once easing credit starts to boost growth, structural reforms will never be implemented, which would jeopardise the future of the whole of Europe.

For this reason, the ECB is proposing a deal. It will keep the money taps open – alongside some fiscal stimulation, as far as the central bank is concerned – on the condition that structural reform takes place. The latter will not happen overnight. So for the moment, Germany and the ECB will only boost the economy to the extent that deflation and a negative spiral can be avoided. In practice, this points to growth rates near 1.5%, barely higher than the productivity increase. In other words, the unemployment rate is unlikely to fall (substantially).

The only other ‘windfall’ that Europe can expect is euro weakness. The US will certainly not object to this: as full employment approaches, a stronger dollar would be helpful.


Global economic growth seems set to slow in the coming years, except, perhaps, in emerging economies that manage to substantially boost domestic demand. The reasons why growth is and will be sluggish vary from country to country. In the US and in the UK, we could see full employment in the not-too-distant future. Subsequently, growth will need to slow in order to prevent higher inflation and unsustainable rises in interest rates. In the EMU, outside Germany there is a lot of slack in the economy. At the same time, it is impossible to rapidly stimulate growth due to sluggish demand.

Chart 3: The EMU crisis will not go away until the banks are able and willing to lend again
Chart 3: The EMU crisis will not go away until the banks are able and willing to lend again

Source: Thomson Reuters Datastream/ECR

Whereas the Fed and the Bank of England are approaching the moment when they have to apply the monetary brakes, the euro area will need very loose monetary policy in the years ahead. This means we expect US interest rates to increase by much more than those in the EMU and that EUR/USD will decline to 1.20 and lower in the coming months and quarters.

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