THE MARKETS are becoming nervous. Though share prices are still high, they are below their recent peaks, particularly in Western Europe. There are signs of volatility and escalating fears.
New geopolitical threats – in Ukraine, Iraq, Syria and Gaza – are accentuating concerns that the global economy may be facing a prolonged period of low growth.
If we are facing a chronic lack of dynamism driven by structural forces such as demographics and technology, the implication is that official interest rates will have to remain at historically low levels for a long time. If concerns over “structural stagnation” are valid, persevering with very low rates is necessary in order to ensure that weak growth does not degenerate into never-ending decline or recession.
This view is not unanimous. Some argue that quantitative easing and the prolonged period of exceptionally cheap money are making things worse, because they risk creating bubbles and asset price instability. But this is a minority opinion. The majority view among economists, which is shared by the major central banks, is that it is still too early to think about tightening policy and “normalising” interest rates. But the dangers associated with the existing policies are being increasingly recognised. Subtle differences of emphasis are now emerging between the various central banks. In particular, though they are not yet prepared to change course, the US Federal Reserve and the Bank of England are now thinking seriously about exit strategies and higher rates.
US short-term economic trends are mixed, but there are signs of gradual improvement. US GDP, after falling by an annualised rate of more than 2% in the first quarter of 2014, partly due to severe weather conditions, rose by a better-than-expected rate of 4% in the second quarter. US economic performance compares favourably with the eurozone and Japan. But the recovery remains weak by historical standards. In spite of the recent GDP rebound, our US growth forecast for 2014 is revised down to a disappointingly low 1.7%. The US housing market, though still healthy, is slowing. House prices increased by 1.1% in May, but on a seasonally adjusted basis prices fell by 0.3%. On a year-on-year basis, the rise in US house prices slowed from 10.8% in April to 9.3% in May, the lowest annual increase since February 2013.
Most significantly, the US labour market remains robust. The US economy created 209,000 jobs in July, fewer than expected and fewer than the upwardly revised increase of 298,000 in June. The US jobless rate rose marginally in July, to 6.2%, also worse than predicted. But the fact that July saw the sixth successive monthly increase in US jobs confirmed that the recovery, albeit inadequate, remains on course.
The Fed will continue to taper its asset purchase programme at a steady pace of $10bn per month, and this process will be concluded around October. But we expect US official interest rates to remain at their current level of 0-0.25% for some time, with the first increase in the Fed funds rate most likely to occur in the second quarter of 2015. Recent increases in annual US consumer price inflation, to just over 2%, may increase pressure on the Fed to move earlier. But the stagnant US average earnings in July will reinforce the view that it can afford to wait.
In contrast to the US, where the key policy uncertainty is the timing of the first Fed interest rate increase, the European Central Bank is mainly worried about the dangers of persistent below-target inflation. Eurozone annual inflation fell in July to a four-and-a-half year low of 0.4%, less than expected. At this level, inflation is less than a quarter of the ECB’s target of “below but close to 2%”. The fall in inflation is partly due to falling food and energy costs. But even if one excludes food and energy, “core inflation” at 0.8% is still less than half the target.
Not everyone agrees that low inflation is a major problem. German analysts and politicians, who traditionally support “hard money” policies, are against measures aimed at pushing up inflation. But the majority view is that the average eurozone inflation rate masks perilous differences between members. Weak, heavily indebted, countries such as Greece, Spain and Portugal are facing outright deflation, and Italy is moving in that direction. For these economies, a prolonged period of deflation or very low inflation would result in a crushing debt burden that could lead to a nasty recession.
The recent stability in the eurozone financial markets is deceptive. The region’s 11.5% unemployment rate is much higher than in the US and the UK, and points to poor growth prospects. In Greece and Spain the jobless rate is 24-27%, which worsens social tensions and makes it very difficult to deal with the underlying problems.
If the tensions in Ukraine lead to serious economic sanctions against Russia, many eurozone economies (including Germany) could be damaged. Given this background, the ECB’s role in avoiding a new downturn will become even more crucial. But after the ECB cut in June its benchmark rate to 0.15%, and its deposit rate to negative, there is only limited scope for more rate cuts. In spite of German disquiet, we expect the ECB to start purchasing assets in the next few months.
The UK remains one of the fastest-growing economies amongst the G7. In the second quarter of 2014, quarterly GDP growth was 0.8%, the same as in the first quarter, slower than in the US but faster than in most eurozone economies. The UK labour market remains strong, with rising employment. The Monetary Policy Committee has continued to vote unanimously for the current policy of keeping Bank Rate at 0.5% and the asset purchase programme at £375bn. We expect the first increase in UK official rates to occur in the first quarter of 2015. But the pressure for an earlier rise in rates is mounting.
An increase in rates in the next two to three months cannot be ruled out. But such a move would be unnecessary and potentially risky in our view. UK inflation is below target, wages are rising very slowly, and Britain’s recovery is still fragile. The MPC should wait.