In the first six weeks of 2019, economic data has been disappointing overall, with manufacturing and global trade data in particular pointing to a severe slowdown in growth.
The main drivers behind the gloomy outlook are relatively tight monetary policy in the US and China; the US – China trade war; confidence sapping political uncertainty in Europe; and some temporary factors such as new emission standards in Germany and the low water levels in the Rhine river.
On a more positive note, prospects for growth, such as they are, are being supported by rising consumer incomes in the major economies and lower commodity prices, which boost real wages, and more fiscal easing measures. Additionally, monetary conditions generally are still supportive of growth.
Still, fear of a global recession – effectively growth below 3% – is mounting. Europe is close to a recession and some economists suspect Chinese growth levels are significantly lower than reported.
We believe that central banks and fiscal authorities are sufficiently alert to excessively low growth to the extent where a recession is unlikely. However, consideration of the outlook within a larger framework is merited.
Do not expect too much from policymakers
Virtually everywhere in the world, central banks use a target of approximately 2% for core inflation (inflation ex-food and energy prices). This target dates back to the period in which the economies grew by 3%-4% annually. With 2% inflation, nominal growth was said to be around 5% and interest rates were therefore also at this level. In other words, there would be sufficient scope for a rate cut in the event of a recession. However, the situation is entirely different now, as low potential growth, an excessive reliance on monetary policy to stimulate growth, and high debt burdens keep interest rate levels low and risks elevated globally.
Global inflation rates
Source: Thomson Reuters Datastream/ECR Research
That is why central banks are almost begging governments to implement structural reforms that boost the growth potential of the economy. A far healthier situation would arise in a scenario where these measures achieve a growth rate of 3%-4%. However, structural reforms are met with considerable resistance in most western countries. That implies that central banks will be compelled to take control of the situation to a far greater extent.
The best thing the Fed can do in this case is to increase its inflation target to approximately 3.5%. This would result in a nominal growth rate of at least 5%, with nominal interest rates ending up at correspondingly higher levels. Moreover, higher inflation reduces the real debt burden. However, inflation will have to be prevented from rising too fast. In times of rapidly rising inflation, nominal interest rates generally tend to rise faster than inflation. In other words, real interest rates rise in this case, which would have a negative effect on growth and could make the high debt levels unsustainable.
Counting on inflation
So, how can inflation be pulled up to approximately 3.5%? So far, it has remained stubbornly low in the west. This is the result of globalisation, soaring debts and the introduction of modern technology. These factors also keep wage increases at low levels. Yet this does not mean that higher inflation cannot be achieved. It may best be achieved in a scenario of full employment and capacity utilisation. This is more or less the case in the US and Germany, for example.
If growth stays above potential under such a scenario (at least 1.8% in the US), wage increases and inflation will automatically come under more upward pressure. In reality, this means that a US growth rate of 2.25%-2.5% would be best from now on. This is still above potential, but not too much. Wage increases and inflation would only slowly reach higher levels in this case, exactly what the Fed would like to achieve.
Fed has adopted ‘patient’ rate stance and signalled flexibility on the path for further balance sheet reduction
Source: Thomson Reuters Datastream/ECR Research
However, what to do in a scenario where the economy still has a considerable reserve capacity, with inflation consequently staying at low levels? Or what to do in a scenario where inflation does not rise significantly due to the aforementioned deflationary forces, even if there is full capacity utilisation? In such cases, it is best to remember Milton Friedman’s statement that ‘inflation is always a monetary phenomenon’. The faster the money supply grows, the more inflation will rise. However, the prerequisite is that the money has to flow to the real economy. This may well mean that public deficits have to increase further and that central banks need to fund this monetarily. It is effectively an instance where necessity knows no law.
In a practical sense, we believe that this policy of monetary funding of public deficits will only be pursued in the next recession if current attempts to boost inflation prove unsuccessful. However, the US is most likely to achieve higher inflation without too many acrobatics, given the country has reached the point of full capacity utilisation. A persistent (excessively) loose monetary policy is probably sufficient to this end. The Fed’s turnaround early this year should be viewed in this light.
Consequently, long-term borrowing costs may drop further as growth slows further and fear of a recession increases. But this would likely herald the start of an uptrend in long-term interest rates, as bond investors will start to discount higher inflation as a result of a more expansionary fiscal and monetary policies.