AFTER a nasty wobble in the immediate aftermath of Britain’s June vote to leave the EU, the equity markets have staged an uneven upturn. Once it became clear that the negative effects of Brexit have been exaggerated, share prices have recovered – both globally and in the UK.
But the markets have displayed recurring concerns over the effectiveness of the tools used by the major central banks. Hints that the US Federal Reserve may decide to edge up its key policy rate, in spite of a mediocre US economic record, have exacerbated fears that early tightening may cause upheavals, particularly in relatively weak emerging markets (EM).
In the event, the Fed’s decision at its 21 September meeting to keep rates on hold was greeted with noticeable relief, with share prices and EM currencies recording strong gains. But the sense of calm may prove deceptive and short-lived. Plans for Fed tightening will return, global growth remains inadequate, and there are new worries that China’s debt is ballooning. The biggest threat of turmoil relates to uncertainties over the US November elections. If the gap in opinion polls narrows further, the markets will have to consider more seriously the possibility of Donald Trump being elected.
The Bank of Japan’s announcement, also on 21 September, that it plans to ease policy further reinforced the upward movement in global asset prices and helped to reassure markets that the main central banks will persevere with a dovish stance, and that there are no plans for early tightening. Although the Bank of Japan kept its key policy rate at its record low level of minus 0.1%, but did not cut it, the markets were reassured by its promise to keep intervening until inflation “exceeds the price stability target of 2% and stays above the target in a stable manner”.
Changes in the BoJ’s bond buying programme, aimed at widening the yield curve and bolster bank profitability, were also seen as confirming the policy-makers’ determination to support the economy. But it will be a tough and slow job. Our forecast shows that Japan’s GDP growth will average less than 1% in both 2016 & 2017. Inflation will edge up from just below zero this year, but will average only 0.7% in 2017, well below the target. Against this unpromising background, one can expect both the BoJ and the Japanese government to inject further stimulus into the economy in the next few months.
The realisation that exceptionally low interest rates and massive injections of QE will not revive growth and push inflation towards its official targets is forcing a reassessment. As low or negative rates heighten risks of instability, we hear renewed demands to use fiscal tools in order to stimulate demand. There are obvious attractions in borrowing at the exceptionally low interest rates available today to finance long-term infrastructure projects. But the renewed enthusiasm for fiscal activism, which is reminiscent of the discredited “pump priming” of the 1960s and the 1970s, must be treated with great caution.
Even if one borrows at very low rates, excessive debt burdens will inevitably increase. Some want to resort to monetary financing, i.e. direct central bank funding of government spending. But this is a highly risky technique, and most independent central banks would be reluctant to use it. Even if these scruples can be overcome, it is well known that spending splurges undertaken in a hurry and without rigorous commercial scrutiny can produce waste and inefficiencies. Improving the infrastructure is important, but can only raise productivity if accompanied by genuine supply-side measures entailing greater competition and deregulation. But strong political opposition by vested interests makes it very difficult to implement such measures, particularly in the EU and Japan.
Eurozone growth remains sluggish. The economy appeared to improve earlier in the year and growth forecasts were upgraded. But more recently there have been worrying signs of relapse. Our forecast shows full-year eurozone GDP growth easing from 1.5% in 2016 to 1.2% in 2017. Indeed, following poor business surveys published recently, the slowdown next year could be even more pronounced. Contrary to expectations, the European Central Bank kept at its September meeting its key interest rate at zero and its bond purchase programme at €80bn a month. But the pause in easing is likely to be temporary.
The European Central Bank kept the door open for more rate cuts and for a larger QE package in the months ahead, and called on the eurozone’s governments to do more to support economic recovery. ECB President Mario Draghi is keen to ease policy further. But he is hampered by continued German scepticism, including a legal challenge that will make it very difficult for the ECB to relax restrictions on its bond buying plan, so as to make current policies more effective.
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The US economy continues to expand at a mediocre but relatively steady pace and the labour market, though volatile, remains basically robust. GDP is forecast to grow only 1.5% in 2016, followed by a gradual acceleration to 2% in 2017. But US economic prospects remain more solid than those of Europe or Japan. The US economy created only 151,000 jobs in August, less than the 180,000 forecast, and well below the much stronger performances in June and July, when 546,000 jobs were added in total. Over the latest three months, job creation averaged more than 230,000 per month, a very satisfactory pace.
The US unemployment rate remains steady at 4.9%, a historically low level. The relatively weak August labour market figures were a major factor persuading the Fed not to raise rates in September, in spite of earlier hints that a rise may be imminent. But the policy-making committee was more divided than usual, with 3 powerful heads of regional Feds voting for an immediate increase in rates. While the Fed’s dovish bloc remains firmly in the ascendancy, pressures for some tightening is mounting. December 2016 the most likely date for the next move, after a turbulent election.
In the UK we have seen additional evidence that the economy performed much better than expected in the aftermath of the June Brexit referendum. Consumer confidence, retail sales and exports improved in recent months, confirming the UK economy’s underlying resilience. The weaker pound helped to reduce the trade gap and attracted foreign visitors to British shops.
While some slowdown in UK growth is still likely in the next 12-18 months, the scale is much more modest than initially feared. Many analysts, after downgrading sharply their growth forecasts in July, are now revising them up. We are now predicting full-year UK GDP growth at 1.7% in 2016 and 1.0 per cent in 2017. The Bank of England’s MPC decision in August to cut rates and expand QE was probably premature and unnecessary. Though a majority on the MPC appears determined to ease policy further, some members are opposing any additional easing. On balance the MPC is likely to adopt only very marginal additional steps in the next few months. The Autumn Statement due in December will show whether the UK will use fiscal tools more forcefully in the future.
David Kern of Kern Consulting was Chief Economist at the British Chambers of Commerce between 2002 and 2016. He was Group Chief Economist at NatWest between 1983 and 2000