The big pivot
What does a move away from monetary policy mean for the world economy?
| 11 Oct 2018
For too long, central banks have dominated financial markets. After the crisis in 2008, they crashed interest rates to ultra-low levels to restore confidence and jumpstart growth. Financial markets responded by rising spectacularly and indiscriminately.
Now, after a decade of extraordinary monetary stimulus, global growth seems to be on surer footing. With it, a pivot away from monetary policy appears to be on the cards. How will this play out? What does that entail?
Growth is back?
A decade after the financial crisis, the reality on the ground is finally better. Most developed economies are enjoying above potential growth. The US is growing at a pace of 3% against an estimated potential of 1.8%. In the eurozone, despite a marked deceleration this year, growth is expected to come close to 2% against an estimated potential of 1.25%. Across all developed economies, unemployment levels are at historic lows and there is gathering anecdotal evidence of labour shortages. In the US, firms are dropping requirements for drug testing and disclosure of criminal records. Non-monetary benefits are also being ramped up to retain workers. US unemployment, at 3.7%, has not been this low since 1969. In Europe, employee compensation has been firming for most of 2018, and is now running well in excess of 2% in the core economies. In Japan, labour market dynamics are displaying acute shortages – there are more than two new jobs opening up for every new job seeker.
The inflation conundrum
Despite the extraordinary tightness in labour markets, there has been remarkably little follow through to inflation. There are several reasons for this. First, the sensitivity of wages to labour market tightness – the proverbial Phillips curve – has diminished in recent years. This is shown in chart 1, where the dark line measures the slope of the Philips curve for the US economy. In recent years, estimates of the slope has fallen sharply, suggesting a diminished link between unemployment and wages. Secular forces such as globalisation, automation and the ongoing shift to services could be at play here. Second, inflation expectations have become remarkably anchored. In chart 2, you can see that the correlation between current and future inflation rates has fallen sharply in recent years. This suggests that sudden spikes in inflation have no staying power. They simply dissipate quickly. This is in stark contrast to what happened in the seventies. The adoption of explicit 2% inflation targets are likely to have made monetary policy more predictable and transparent and could have resulted in the benign ‘anchoring’ of inflation expectations.
Even though inflationary pressures remain benign, rock bottom unemployment rates and labour market shortages are forcing central bankers to recalibrate interest rates. The US Federal Reserve is the furthest forward; it started hiking interest rates in 2016 and has raised interest rates seven times to 2.25%. Despite the vagaries associated with the Brexit negotiations, the Bank of England has raised its policy rate twice and the European Central Bank has given strong guidance that quantitative easing will conclude at the end of 2018 and interest rates will start rising after September next year. Even in Japan, where deflationary forces are deeply entrenched, the pace of quantitative easing has slowed markedly from an annual pace of 80 trillion yen to just under 30 trillion yen. Central banks are increasingly wary that inflation expectations might become unanchored if they keep interest rates at rock bottom levels at a time of little spare capacity.
A fiscal thrust
Even as monetary policy is being dialled back, populist parties are pursuing a more activist fiscal stance. Drawing support from the deep resentment that has built up over decades against the unequal distribution of gains from globalisation, automation and even quantitative easing, they are promising targeting fiscal spending to reduce inequality. This is particularly true for the US, where the Trump administration is undertaking an extraordinary fiscal expansion, that is adding close to 60-80bps to growth, at the peak of the economic cycle. This is unorthodox, unnecessary and unprecedented. In the UK, Prime Minister May declared at the Conservative Party Conference that austerity is over; a post-Brexit UK government under Labour or the Conservative Party is set to boost spending on public investment. In the euro area, there is a dangerous battle taking place between the populist agenda of the Italian government and the European Council’s more conservative stance. In reality, an easing of the fiscal stance in Germany will go a long way to reduce the internal imbalances in the euro area. Absent that, there will be a constant drumbeat of populist governments seeking to redress these imbalances through looser fiscal constraints.
The policy pivot away from monetary to fiscal is a dramatic shift from the post crisis era of financial repression. As short-term interest rates continue to rise, the cost of capital across the global economy will increase, tightening financial conditions for businesses and consumers. If the pace of monetary withdrawal is gradual, measured and well calibrated, then earnings could support asset prices even if valuations adjust lower. Key to this benign scenario is that inflation expectations remain stable. An increase in productivity boosting capex that allows wages to rise without raising inflation is also very important. In this regard, the nature of the fiscal boost is critical. Spending on investment as opposed to simple tax cuts have the best chance of success.
While the pivot is greatest in the US, the impacts will reverberate across the world, particularly to emerging markets, as global funding costs are inextricably linked to the US interest rates. For emerging markets which have borrowed in dollars, there is a double tightening of financial conditions underway. For commodity importers, there is a further squeeze on domestic purchasing power.
As unorthodox monetary policy gives way to unorthodox (pro-cyclical) fiscal policy, long-term risks are rising. Fiscal easing is being introduced at a time when debt burdens are unsustainably high. In the US, annual deficits are projected to reach 1 trillion from 2020 onwards. It remains unclear how this unsustainable fiscal trajectory is ultimately paid for and by whom.