THE SOARING US dollar dominates the markets, as divergences between the US, the eurozone and Japan become more evident. In the past six months, the dollar has seen rises of 11% against the euro and 9% against the yen. The main drivers are stronger US growth and the widening yield gap in favour of US bonds. Ten-year US Treasuries traded recently near a 15-year high against ten-year German Bunds, the eurozone benchmark. In the short term, a higher dollar can help the eurozone and Japan, which are pursuing aggressive policies to raise inflation and stimulate growth. But, if upward pressures on the dollar escalate, its strength could become malignant and the blessing could become a curse.
The trans-Atlantic policy gap will widen in the near term. As the US economy recovers, the Federal Reserve will end its bond-buying programme, and start raising official interest rates before mid-2015. In contrast, the European Central Bank (ECB) will ease its expansionary policies further. It will widen its programme of private-sector asset purchases, and consider outright buying of government debt, in order to reduce the risk of a lapse into deflation and help revive the feeble eurozone economy. The Bank of Japan is also struggling to revive an anaemic economy and push up inflation. If the dollar helps to avoid recessions in Europe and Japan, the US will tolerate the effects on the competitiveness of its exports. But beyond a certain point, the dollar’s strength could become a source of instability, with very negative effects.
Flight to safety
As the markets anticipate further large exchange rate movements, volatile capital flows will inevitably build up. The impact on emerging markets could be highly damaging if, as seems likely, investors become more risk-averse and start moving their funds into safer and more stable developed markets. If the dollar rally intensifies, capital outflows from emerging economies will intensify, as investors choose to put their cash into relatively safe and attractive US assets.
These shifts are already under way, as emerging market bonds and currencies, notably the Brazilian real, fell in recent months. Over time, these destabilising flows will more than offset any benefits to their export competitiveness that may result from a weaker currency. Even in some developed economies, the benefits of a lower dollar may be eroded. Recent developments have pushed bond yields in some southern European countries to unsustainably low levels. When market sentiment catches up with reality, the resulting outflows could trigger a new crisis.
The eurozone’s weakness is becoming more pronounced. Figures showing zero GDP growth in the second quarter of 2014 were followed by surveys pointing to continued low activity in the third quarter. The composite purchasing managers (PMI) index fell to a ten-month low in September, mainly reflecting worsening performances of France and Italy. Eurozone demand is inadequate, the banking sector is under-capitalised, and bank lending is subdued.
These problems are aggravated by the adverse effects of the sanctions on Russia. Eurozone unemployment remains historically high at 11.5%, while annual inflation is at a five-year low of 0.3%. In Italy, Spain and Belgium, consumer prices are now lower than 12 months ago, and there is a real risk that deflation will make their debt burdens unsustainable. While it is too early to judge whether last month’s ECB measures will work in time, the immediate situation is dire.
ECB president Mario Draghi wants to reinforce the stimulus to alleviate the crisis. But he is encountering strong opposition from Germany to the inclusion of Greek and Cypriot private sector assets in the central bank’s programme. The more radical step of outright quantitative easing – ie, purchasing government bonds in the same way that other central banks are doing – is still not on the ECB’s agenda. However, if stagnation continues, opposition to such a step may fade. Our 2014 GDP growth forecast remains 0.9%, but the downgrade risk has increased.
US surging forward
In contrast to the sluggish eurozone, the US economy is surging, even though the housing market is cooling and overall performance is mediocre by historical standards. The National Home Price Index increased by 5.6% in the year to July 2014, down from 6.3% in June, and well below double-digit annual increases seen as recently as February. But other indicators show stronger US growth.
Job creation accelerated in September; the economy created 248,000 new jobs, better than expected, while revised figures show that the number of new jobs created in August was much higher than first estimated. The unemployment rate fell to a six-year low of 5.9%. Second-quarter GDP growth has been revised up, from an annualised rate of 4.2% to 4.6%. The figures confirm that the US recovery is broadly based and our growth forecasts are being upgraded, to 2.1% for 2014 and 2.7% for 2015. In spite of stronger job and GDP figures, the Fed will not modify its timetable. The tapering of the asset purchase programme will end in October, and the first increase in the Fed funds rate is likely to occur in the second quarter of 2015.
UK growth remains amongst the strongest in the G7. Revised figures show the downturn in 2008-09 was not as steep as estimated, and the subsequent recovery was stronger. The UK labour market is resilient and flexible, with 774,000 more people in work over the past year. But the economy is still facing challenges, the most serious being the “twin deficits” – budget and current account.
In spite of strong GDP growth, the fiscal hole is excessive, and borrowing this financial year is likely to be bigger than predicted by the Office of Budget Responsibility at the time of the March 2014 Budget. The current account deficit, at about 5% of GDP in the first half of the year, is unsustainably large. The minutes of the September MPC meeting reveal two out of nine members voted for an immediate rise in rates. But the MPC can afford to wait, with wage pressures still weak and inflation below target. The no vote in the Scottish referendum will underpin stability, and we expect the first increase in official interest rates in the first quarter of 2015.
David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist