Gavyn Davies
Nov 24 07:00
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?
In recent days, the 2014 oil shock has induced central banks to ease monetary conditions further. Admittedly, many analysts think that monetary policy is now firing blanks. But lower oil prices, if maintained, will themselves boost global GDP by 0.5-1.5 percent next year. Furthermore, the global fiscal drag that has dampened the recovery in the past four years has now virtually disappeared.
It may not be enough to spell the end to secular stagnation, but the new policy mix should point to a somewhat better year for growth in the developed economies in 2015 – perhaps even in the euro area, where pessimism has recently become quite extreme.
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It is now accepted by most economists that the repeated disappointments in global growth projections since 2010 have occurred because aggregate demand has fallen short even of the sluggish growth in potential GDP, in each successive year. Global economic policy has not been able to sustain demand growth at the rate required to stabilise inflation at the 2 per cent target in most economies.
This is sobering, in view of the unprecedentedly expansionary monetary policy that has been in place since the crash. But aggressive action by the central banks has been unable to offset fully the tightening in fiscal policy that all the major economies have embarked upon since 2010. The easy monetary/tight fiscal stance has emerged everywhere, though with somewhat different timing from one major economy to another. Its success has been limited:
The graph above shows some broad brush measures of the overall stance of fiscal and monetary policy in the major developed economies since the crash1, and also the rate of growth in GDP relative to potential.
There have been three phases of policy:
• From 2008-09, both fiscal and monetary policy were eased simultaneously, in order to soften the crash. This worked to some extent, leading to above trend growth in 2010.
• From 2010-14, initially encouraged by the IMF and the G20, policy embarked on a period of fiscal consolidation, and the central banks moved into a second phase of quantitative easing.
This did not result in a robust recovery in GDP. In fact, growth was generally stuck at or below potential in this phase and, time after time, initially optimistic economic forecasts had to be revised sharply downwards.
• The third phase started to take shape in 2014. Fiscal authorities, probably accepting that budget multipliers have proven higher than they expected during the second phase, have shifted a long way from austerity towards neutrality. This was led by the US and the UK but is now being followed by Japan and even the euro area. Central banks, however, have not responded to this shift by withdrawing monetary support. True, the Federal Reserve and the Bank of England have halted QE, but the Bank of Japan and the ECB have stepped into the breach. The overall rate of global central bank balance sheet expansion is actually accelerating.
How confident can we be that the third phase – monetary expansion and fiscal neutrality – will prove significant and durable?
On the fiscal side, there is little doubt that the US and Japan have now stopped tightening budgetary policy for at least a couple of years. In the euro area, the originally planned tightening in 2014 and 2015 has also now been replaced by a neutral stance, due to delayed consolidation in France and Italy.
More surprisingly, there is market chatter that some Anglo-Saxon policy makers returned from the G20 meetings in Australia last weekend speculating that the fiscal policy stance in the euro area might even be eased in the next year or two. Reportedly, they were optimistic that the Juncker plan for €300 billion of extra investment will have some substance, and that the gap before this plan takes effect could even be filled with an emergency fiscal easing of (say) 1 per cent of GDP in 2015 and 2016.
This sounds improbable, based on what is being said in public, but the Germans might conceivably have decided that a controlled fiscal easing in the euro area would be preferable to open-ended purchases of sovereign debt by the ECB, which they would not fully control. We may discover more at the next European summit on 18-19 December.
Turning to global monetary policy, the oil shock is clearly having a major impact on central bank thinking. Initially, many economists said that central banks would “look through” the decline in headline inflation, because core inflation would not be changing. In fact, however, they have shown themselves to be very worried that the drop in headline inflation will, this time, unhinge inflation expectations, increasing the risk of getting stuck in a deflation trap.
The Bank of Japan moved first, attributing its latest monetary easing directly to the effects of lower oil prices. On Friday, ECB President Draghi, in his most explicitly dovish speech ever, said that inflation expectations are “excessively low” and that reported inflation must be raised “without delay … as fast as possible”. Lower oil prices seems to have increased his sense of urgency considerably. Even the Federal Reserve, which is normally very resistant to placing too much emphasis on headline inflation rates, seems concerned about persistent “lowflation”.
Finally, the interest rate cuts by the People’s Bank of China on Friday may not be a big deal in themselves, but they do suggest that the drop in headline inflation will lead to generally lower rates in the emerging world as well. Apart from lower inflation, the exchange rate effects triggered by monetary easing in Japan and the euro area are causing many other countries to act.
So the oil shock is directly boosting global growth, and is also triggering a further major monetary easing, just as fiscal tightening is becoming neutral. Without engaging in irrational exuberance, it seems quite possible that, for the first time in half a decade, global growth forecasts for 2015 will need to be revised upwards, not downwards.
[1] The forecasts for 2015-16 are estimates by the author based on latest policy announcements in the major economies.
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