Et tu Joe Six-Pack? - Amidst the turbulence of the last few weeks, sources of comfort have been hard to come by. Emerging market economies have continued to struggle. Global manufacturing and trade has remained weak. The collapse in oil prices has hurt not only the global economy but has been sucking liquidity out of financial markets. Global equities have had their worst January since 2010. The one big remaining positive seemed to be decent domestic economic fundamentals in the US and Europe. It was hoped that domestic demand – in particular consumers - in these economies would tide the global economy over until some of the headwinds elsewhere started to ease. Data this week challenged this view.
Consumers are receiving huge windfalls from lower oil prices. However, it does not seem they are spending them.
Nick Kounis Head of Macro Research
- Recent data from the US and eurozone signal risks to the outlook for consumer spending, which had been doing well up until now
- The global turbulence and tighter financial conditions may have made consumers reluctant to spend their oil windfalls…
- ...but it could be that we are just witnessing a lag between lower oil prices and spending
- It is therefore too early to say that consumers have succumbed to the global headwinds
- If consumers really are retrenching, central banks will need to come into action much more decisively to break the vicious circle
Weak domestic data in the US and eurozone
Two reports in particular suggested consumer spending may be weakening on both sides of the Atlantic. The first is the ISM nonmanufacturing index in the US, which fell significantly in January. This index covers the more domestically-oriented sectors in the US economy, which have been relatively resilient despite the contraction in manufacturing, so it caused concern that the weakness is spreading. Indeed, the index roughly tracks growth in consumer spending (see chart) and if sticks at these levels, this would suggest that consumer spending would slow to rather modest growth rates. It would therefore no longer be strong enough to overshadow the drag from net exports and falling energy investment. Meanwhile, in the eurozone, retail sales showed some recovery in December, but were still down in Q4 as a whole. As in the US, consumers have been an important part of the moderate recovery story so far.
Consumer retrenchment a possibility
Consumers are receiving huge windfalls from lower oil prices. However, it does not seem they are spending them. One possibility is that turmoil in financial markets is causing uncertainty about the outlook, meaning that households would rather save. In addition, the weakness in markets – and in the US – the strong dollar – have seen a sharp tightening in financial conditions. Perhaps this is dampening demand. If consumers do not spend, we will be just left with the negative fall-out from lower oil prices stemming from the effects on oil producers.
Not so fast
However, we may well be jumping to conclusions. It could be that we are just witnessing a lag between falling oil prices and higher spending. This is a phenomenon we have seen in the past as sometimes households take time to adjust. This point of view is supported by other signals from the data. For instance, consumer confidence in both the US and the eurozone has remained at relatively high levels. If people were really spooked into saving you would probably expect to see consumer confidence slumping. In addition, there are signs of some of the components of consumer spending that provide us with more confidence. For instance, while eurozone retail sales were weak in Q4, car registrations were strong. Similarly, spending on durables in the US was also decent last quarter. These are not the kind of items you buy when you are scared about the future.
Labour markets still in good shape
One thing consumers certainly seem to have going for them is robust labour markets. In the US, nonfarm payrolls were moderated in January, growing by 151K. However, this looks like a correction for strong gains in previous months and the 3-month moving average remained well above 200K. In the eurozone, employment has also continued to expand and unemployment has been steadily coming down, though it remains unacceptably high. Although labour markets can lag demand, there are no clear signs that the domestic economies in the west are in trouble in this area up until now. Overall then, despite the disconcerting signs of this week, it is probably too early to say that consumers have succumbed to the global headwinds.
Here comes the fire brigade
But what if they have? What if consumers are really starting to retrench because of the uncertainty and tightening of financial conditions caused by the market turmoil? Then we will need global policymakers to come into action to break the vicious circle. In actual fact we are already seeing signs of this. Central banks are reacting to the downside risks to growth and the sharp deterioration of the inflation outlook. The Fed seems to be increasingly reluctant to raise interest rates again at its next meeting in March and indeed we expect it to wait. For instance, the influential New York Fed President Bill Dudley said this week that the FOMC would need to take the significant tightening of financial conditions into consideration. At the same time, we have seen the BoJ move to negative rates on new excess reserves, and the ECB signalling that it would take further action in March (when we expect a further rate cut). The recent decline in the US dollar, has strengthened other currencies adding to the pressure for central banks outside of the US to ease. There can be little doubt that the global economy could do with additional monetary stimulus given subdued growth and very low inflation.
Maybe central banks need to go much further
Of course if domestic demand really does start to fall away, central banks will need to be much more decisive than they have been prepared to be in recent weeks. The risk is that it may take them some time to get there if this scenario does start to materialise given the baggage of the past. After raising interest rates in December, the FOMC would have to do a rather embarrassing U-turn. ECB President Draghi may need time to generate support in the Governing Council for a new bazooka. Meanwhile, after launching a huge asset purchase programme a few years ago, the BoJ has seemed to return back to its more conservative self in adding to that stimulus when necessary. The most likely scenario would still be that global central banks would get there in the end, especially as a sharp slowdown in demand would seriously increase the risk of deflation.
But do they have the ammunition?
That leads to the question of whether central banks have run out of ammunition. We think there is still firepower left. Interest rates could go (more deeply) negative. Asset purchases can still be stepped up. In the case of the ECB this would involve the politically-sensitive move of dropping its capital key (GDP and population weights) to allocate asset purchases between countries and move to an ‘outstanding debt’ key. This would allow the ECB to step up its government bond buys further. Of course, monetary policy would need to be supported by other policymakers in the scenario. The case for fiscal stimulus would come back on the table, especially in countries that have built themselves some room for manoeuvre.
Not out of bullets yet
Looking further forward, we do not think the ECB has run out of space to ease policy further. We think central banks in Scandinavia, such as Sweden’s Riksbank have shown that the deposit rate can come down further. The room to sharply step up QE under the current design is limited, given the use of the capital key to allocate purchases between countries and the size of the markets for debt securities in particular countries. There are potential strains especially for German securities under this system. However, if the ECB really needs to go further it could change the modalities of the programme to give it more room to step up QE. For instance, if a more adverse scenario developed, it could drop the capital key and allocate purchases on the basis of outstanding debt securities.