Disappointing economic data globally and turmoil and volatility on financial markets have triggered a fierce debate about economic policies, in particular monetary policy. Critics of the policies followed in recent years have suddenly come out in droves arguing that monetary policy has failed, is destabilising the global economy and should be reversed. Supporters of pursued policies argue the opposite. Central bankers are unlikely to follow the critics (any time soon, anyway) as a reversal in policy would have to be based on a total change of the underlying monetary ideology, which is unlikely, and would represent a complete leap in the dark.
I don't think this is something monetary policy can fix, nor do I believe that lower trend growth is caused by monetary policy
Han de Jong Chief Economist
Recent data shows deteriorating business confidence in Europe and the US
US durable goods are a bright spot, suggesting stronger conditions in the industrial sector
A fierce debate is developing over the appropriateness of monetary policy
Central banks are unlikely to change course, more easing is coming, but fiscal policy should also be used
Structural reform should be stepped up to improve potential growth
Recent economic data has generally disappointed, though with a number of exceptions. Business confidence in Europe and the US is weakening. Germany's Ifo index fell more than expected in February and for the third month running.
The European Commission's index of economic sentiment, which includes consumer confidence, fell for the second time in succession in February. And the Markit PMIs for the eurozone were also weaker than expected in February. Similar indicators in the US were equally discouraging. The Markit PMI for the services sector was a particular downer, falling from 53.2 to 49.8. The services sector is the bright spot in the economy and we can do without such weakness. it must be said, though, that this gauge has no track record worth speaking of.
It seems to me that a recession in the US is very unlikely, as I have argued before. Recent European weakness is probably the result of disappointing world trade growth and the fact that the depreciation of the euro is losing its effect. Nevertheless, growth in the eurozone economy is broadly based and, as such, not too vulnerable.
Eurozone inflation needs close watching. January inflation was revised down and the early data for February shows a further decline back into negative territory.
On the more positive side, eurozone credit continues to grow (at a very modest pace). And the US housing market continues its recovery. Perhaps most positive in recent days was the US durable goods orders report, showing a strong bounce in January, following weakness in December. Together with decent retail sales reports and the strong report on US industrial production this suggest that the downturn in US manufacturing may actually be behind us.
A fierce debate about policy
Policymakers, and commentators, are in uncharted territory. Only years, if not decades from now, will economists produce a final verdict on the current period. It really wasn't until Milton Friedman and Anna Schwartz published their seminal A Monetary History of the United States in 1963 that policies followed in the 1930s were properly assessed.
Critics of the policies that have been pursued see the current weakness in the global economy as proof that these policies have failed. That surprises me. It seems to me that a lot of progress has been made since 2007/08. I would simply argue that, obviously, the healing process has not been completed. A setback in this process does not mean there have not been lots of positives, nor that a radical change in policy is required.
Lots of positives
Let me list a range of improvements. The globally economy was staring into the abyss in 2008 and a depression was a distinct possibility. Resolute action by policymakers, employing fiscal as well as monetary policy stimulus, prevented a depression. The recovery that started in the US in 2009 is still ongoing. Europe sank into a second recession in 2011/13 but that was related to the euro crisis. US household debt ratios have declined materially since 2009. Total debt in Europe has perhaps not declined, as some argue, but I think it is now resting on stronger shoulders than before, making the system more stable.
Then there are several important areas where imbalances have been reduced. Government finances are in better shape. International payment imbalances have been reduced. Banks have raised their capital positions significantly. Corporate balance sheets have been improved and profitability is generally healthy. European leaders, despite all the stumbling they seem to do, have managed to make very significant improvements to the governance around the euro.
A question we must ask is how disappointing the current economic recovery really is. Clearly, in terms of GDP growth, this is a very weak recovery. On the other hand, the improvements in labour markets have more or less matched those in earlier recoveries. This combination of weak GDP growth but 'normal' recovery in labour markets suggests that trend growth is much weaker than during earlier recoveries. I don't think this is something monetary policy can fix, nor do I believe that lower trend growth is caused by monetary policy, as some argue. What they assert is that interest rates are so low that they allow funding for investment projects with very low returns to investment which drags down productivity growth. That does not make sense to me. If it were so, we should have seen strong (growth in) investment spending, which we have not.
My reading of economic developments is that the process of healing following the bust of 2008 has not been completed yet and that more time is needed. The improvements mentioned above have come at the expense of increasing imbalances in other parts of the world economy, in particular in EMs: overvalued currencies, too loose monetary policies and excessive credit creation. These imbalances are now correcting and this process needs time to play out but is haunting advanced economies through a reversal of currency trends, reduced economic growth in EMs and financial market volatility.
US Policy tightening started effectively in 2013, not 2015
Many commentators argue that the vulnerability of the economic and financial system are evidenced by how a single rate hike in the US appears to have contributed to the turmoil. I think this ignores an important fact. US monetary policy went into reverse not in December last year when the Fed raised rates, but in 2013 when the Fed started tapering.
Several academics have constructed alternative measures of the US Fed Funds rate to reflect the impact of unconventional policies in terms of interest rates. What these measures show is that 'shadow Fed funds rates' went significantly negative as a result of unconventional policy measures but that a meaningful degree of monetary tightening has taken place since 2013. The economic weakness of recent months is perhaps more the result of this effective tightening than the result of too loose policies. If that is true, the recommendation by some that interest rates should be raised (and not only in the US) would be exactly the wrong thing to do.
I am glad I am not a central banker having to decide between these two views as things can be said for both views, but they lead to opposite policy recommendations. Having said that, I am more a supporter of the policies that have been followed than a critic. In addition, I think central bankers are very unlikely to change their thinking and reverse their policies at least any time soon. Doing so would imply a total change of their belief system. Reversing policy would also be a complete leap in the dark, a risk that central bankers are not inclined to take.
Negative side effects
This does not mean that current policies do not have unwelcome side effects, nor that the recent economic weakness does not need a response. When the Bank of Japan introduced negative rates recently, they tried to mitigate the negative effects on banks by introducing a tiered system. We will have to wait and see how effective such an approach is in protecting the banks and if it shields the banks, how effective it still is as a policy tool. Another side effect is what the liquidity created by central banks does in financial markets. Many argue that it is creating bubbles left, right and centre. I am not so sure. A bubble is a situation when the valuation of assets is persistently and significantly higher than their underlying value. It is easy to figure our whether or not and to what degree this applies, but it does not look to me as though we currently have a lot bubbles everywhere. Nevertheless, it is something policymakers must consider.
The ECB is virtually certain to announce additional policy measures when the Governing Council meets next on 10 March to support economic activity and bring inflation back to its target. One must assume that they will also try to assess possible negative side effects and mitigate them. The US Fed's policy committee meets a few days later, 15/16 March and it will be interesting to see to what extent the hawks stick to their guns. Another rate hike seems extremely unlikely, but the so called dot plot will reveal what the various FOMC members expect for monetary policy during the remainder of the year and beyond. In December FOMC members were expecting, on average, four 25 bp rate hikes in 2016. No doubt, this will have fallen, but by how much? Recent communication by various FOMC hawks suggest they are adjusting their views as economic data disappoints.
Central banks cannot be the only policymakers doing something to keep the economy on a growth trajectory. General reluctance to use fiscal policy will prevent the use of that policy tool, even if it became very desirable. That is a pity.
Structural reforms should be implemented to boost trend growth. Unfortunately, it is hard to see a high sense of urgency as vested interest are standing in the way of necessary reform and policymakers do not have the courage to act.
What we are left with then is a global economy that is growing very modestly and will continue to do so.