ALTHOUGH THE US Presidential campaign has been unusually acrimonious, the financial markets have remained relatively calm. The belief that Hilary Clinton will almost certainly win the race has created a deceptive sense of composure.
Most equity markets have fluctuated narrowly near to their multi-year highs. But the illusory tranquillity is likely to come to an end before the end of 2016, whatever the outcome of the US elections.
The markets clearly prefer a Clinton victory, because a Trump win could unleash an even bigger upheaval than Britain’s vote in favour of Brexit. But if a victorious Clinton helps the Democratic Party to win control over one or both Houses of the US Congress, the markets would become concerned that this could encourage policies that are unfriendly to business, including higher taxes.
That the Fed appears increasingly likely to raise interest rates at its December meeting, whatever the result of the elections, will inevitably be an additional source of turbulence, at a time when the US economy is still too fragile to withstand new shocks.
Banks losing influence
More fundamentally, there are growing anxieties over the fact that the main central banks are losing their ability to influence economic activity; their credibility is rapidly shrinking, even though the global economy has clearly not yet returned to normal.
There are also signs that inflation is starting to edge up in many places. This partly reflects the upturn in energy and commodity prices seen in recent months. But one cannot exclude the possibility that the massive monetary stimulus injected into the global economy since 2008 is at long last starting to have upward effects on inflation.
One major exception is Japan, where inflation remains in negative territory, and both the Bank of Japan and the Abe government would welcome higher inflation. Elsewhere, inflation is still low but is clearly edging up. In China, annual consumer price inflation accelerated in September to 1.9%, up from 1.3% in August; this was the highest annual pace since June.
Eurozone inflation rose to a two-year high in September. This is welcome news for ECB President Mario Draghi, who has viewed fighting stagnant prices and feeble growth as his main policy aim in recent years. But at 0.4%, ECB annual inflation is still very weak, and much lower than the ECB target of “below but close to 2%”.
Until recently, it was generally thought that the ECB would regard the modest upturn in inflation seen so far as inadequate, and would introduce further stimulatory measures in the next few months.
ECB expected to refrain from easing
While this is still a possibility, the situation is changing. The markets now expect that the ECB will refrain from easing policy further in the next 6-12 months. This switch to a more cautious stance is partly driven by recent signs of modest economic improvement, even though growth remains weak. The composite eurozone purchasing managers index (PMI), which combines manufacturing and services, rose to 53.7 in October, the highest reading in 2016 and a level that signals further expansion. Our eurozone full-year GDP growth forecast for 2016 remains unchanged, at 1.5%, but our 2017 GDP forecast is being upgraded slightly.
However, the ECB’s new caution is also influenced by concerns over a future upturn in inflation, and by fears over the adverse effects of its stimulus programme (particularly negative interest rates) on bank profits and on financial stability generally.
German banks and German politicians have been particularly vocal in expressing opposition to the ECB’s ultra-loose monetary policy. Mario Draghi is not in a position to tighten policy at present. In the face of serious problems facing the Italian banking sector and Deutsche Bank, the largest German Bank, the ECB is effectively compelled to maintain an accommodative policy stance, to reduce the risks of a wider banking crisis.
At the same time Draghi cannot afford to ignore wider political considerations. The German national elections, due in the autumn of 2017, will intensify attacks on the ECB by German politicians, who are convinced that QE and negative interest rates are damaging the economy, and will cause in due course higher inflation and financial instability. These criticisms are now finding greater sympathy in other countries, notably the UK and the US, and this helps to erode further the credibility of the main central banks.
Brit’s unexpected growth; at a price
Britain’s economy performed much better than expected in after the Brexit vote. GDP growth eased from 0.7% in Q2 2016 to 0.5% in Q3, a much stronger pace of expansion than analysts predicted. But the UK has also led the way in the current global upturn in inflation.
Consumer prices rose by 1.0% in the 12 months to September 2016, up from 0.6% in August; it was the highest annual inflation figure since November 2014 and a considerably larger jump than the markets expected.
There is no direct evidence that sterling’s near-20% drop against the US dollar since the referendum decision to leave the EU was the driver of September’s price leap; but this fact will add to concerns over future trends, since higher import costs resulting from the weaker pound will inevitably exert stronger pressures on domestic prices in 2017.
An upturn in inflation is politically embarrassing for the government, because it squeezes the purchasing power of UK consumers. Higher prices will also reinforce mounting criticisms against the MPC’s decision in August to cut interest rates and increase QE.
Mark Carney’s leadership at the Bank of England has been under serious pressure since the Brexit referendum. Carney was seen as being too close politically to George Osborne, the previous chancellor, and he was repeatedly blamed by the “Leave” campaign as being too supportive of the “Remain” camp. Despite committing to the role until 2019, his position is weaker following criticisms of QE made by prime minister Theresa May. Given the new UK economic and political background, it seems unlikely that we will see further monetary easing in the next few months.
US economic performance remains pedestrian and below-trend, with disappointing growth. Despite the third quarter improvement, full-year GDP growth is forecast at only 1.5% in 2016, followed by a moderate strengthening to 2.1% in 2017. The labour market is expanding, but at an inadequate pace. The US economy created 156,000 jobs in September, well below the expected increase of 175,000. The unemployment rate edged up to 5.0% in September, up from 4.9% in August, and slightly worse than predicted. Longer-term trends point to a clear deceleration.
In the first nine months of 2016, US job-creation averaged about 178,000, a clear slowdown from the monthly average of some 229,000 jobs in 2015 as a whole. However, annual consumer price inflation rose in September to 1.5%, markedly above the 1.1% US inflation in August and the highest figure since October 2014; core consumer inflation, which strips out food and energy costs, was 2.2% in September, and has remained consistently above 2% since November 2015.
Although the US economy is still weak, signs of rising inflation will reinforce the arguments for a 25 basis points rise in rates at the Fed’s December policy meeting. We expect this to be followed by two additional 25 basis point increases before the end of 2017.
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
Table 1: GDP Growth – Major Economies
% Change on Previous Year
Sources: Actual figures from official sources
Forecasts from David Kern, Kern Consulting
Table 2: Official Interest Rates
Forecasts for Next 2 Years
|Actual||Forecasts – end-quarter|
|US Fed Funds Rate||0.25-0.50%||0.50-0.75%||0.50-0.75%||0.75-1.00%||1.00-1.25%||1.50-1.75%|
|ECB Refi Rate||0.00%||0.00%||0.00%||0.00%||0.25%||0.50%|
|Japan Overnight Rate||-0.10%||-0.20%||-0.20%||-0.10%||0.00%||0.25%|
|China base interest Rate||4.35%||4.10%||4.10%||4.10%||4.35%||4.60%|
|UK Bank Rate||0.25%||0.25%||0.25%||9.50%||0.75%||1.50%|
Sources: Actual figures from official sources
Forecasts from David Kern, Kern Consulting
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