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With the minutes of the FOMC March 18-19 meeting about to shed light on the Federal Reserve's decision to pursue tapering and opt for qualitative forward guidance, we take a look at Yellen's economic dashboard. Peeking under the hood, progress on the inflation and labor market front points to further tapering to the tune of $10 billion at its late-April meeting with asset purchases ending in the fall. However, given the existing labor market slack and subdued inflation readings, a federal funds rate hike is not foreseen until Q3 2015.
As the six-week Indian election process begins, we consider whether recent optimism about the outcome is justified. The run-up to the elections has seen a major rally in India’s financial markets. Share prices have been scaling record highs and the rupee has appreciated. This confidence is being driven by the opinion polls, which suggest that the opposition Bharatiya Janata party (BJP) – viewed by investors as more business-friendly than the incumbent Congress party – will form a coalition government in May. But the new government will still have to operate in the same unfavourable environment, which includes rising corporate debt and fiscal inflexibility, so we think this optimism is unfounded.
In recent years several observers have suggested that higher inflation targets might be economically beneficial. We examine the case for this, but find it unconvincing. There has been a large fall in the risk premia embedded in government bond yields over the past 25 years. Higher inflation targets would risk reversing some of these gains. We also doubt that higher inflation targets would yield the additional policy flexibility that is sometimes claimed. Nevertheless, we do detect a shift by central banks over recent years towards more tolerance of inflation risks at the margin – as seen in the adoption of ‘forward guidance’ and more ‘flexible’ inflation targeting.
Falling real earnings have been a particularly gloomy aspect of the UK economy's performance in recent years. Inflation, elevated by rising commodity prices, tax hikes and weak sterling, has outstripped growth in earnings, which have been kept down by high unemployment and stagnant productivity, for six years in succession. But the start of a sustained rise in real pay could begin as soon as the next month or two. A tighter labour market, recovering productivity and a reversal of the shift seen in recent years towards part-time work should lift pay packets. Meanwhile, government policies, weak pipeline price pressures and the stronger pound should all help to keep inflation down. But while we expect growth in pay to return to pre-crisis rates over time, a full recovery will not be free of obstacles.
Yellen's remark that the "considerable period" between the end of QE and the first rate hike would "probably mean something on the order of around six months," shocked markets last week. Although we believe Yellen's intent wasn't to indicate a spring 2015 rate hike, we take an in depth look at the consequences of such early tightening using our Global Macroeconomic Model. In our scenario, we assume that the Fed would start indicating a future rate hike around Q3 2014, leading to an ex-ante market reaction. Results show that the economic consequences of premature tightening would run counter the Fed's double mandate of full employment and price stability, but the slowdown would not be a sudden stop.
Central banks and other organisations conduct a variety of surveys of credit conditions. In recent years these have provided useful leading indicators of economic activity – especially either side of the global financial crisis. What are the surveys telling us now? Overall, the message is a positive one, especially for the major economies where banks in general are continuing to ease lending standards for businesses as a whole. There are also some interesting details – the surveys suggest downside risks for the US housing market and restrictive lending conditions in emerging markets but an apparent lack of credit restriction in the Eurozone ahead of the Asset Quality Review, which had been considered a risk factor in this regard. The surveys also generally support continued solid growth in Japan and the UK.
World trade growth was unusually slow in 2012-13, the result of a number of factors including a weak Eurozone, a slowdown in the BRICs, slow growth in services trade and possibly the ‘re-shoring’ of production. The latest indicators suggest the cyclical components behind this slow growth may be easing, but the pace of trade growth still remains relatively subdued and indicators for early 2014 are mixed. More structural factors may be slower to improve – the supply of trade finance in emerging markets is increasing but at a moderate pace and evidence from the US suggests re-shoring may be gathering pace there. The recovery in services trade also remains sluggish despite the rally in financial markets over the past year.
The political situation in Ukraine remains tense, with a lingering risk of military conflict with Russia. We present two possible negative scenarios - in the first a conflict between the two countries disrupts gas supplies to Europe, forcing up prices. But Russia itself is the biggest loser thanks to massive capital flight and the resulting financial stress. In the second, a more severe global impact ensues as Russia is subjected to trade sanctions, resulting in a sharper rise in global energy prices. We conclude that trade sanctions look relatively unlikely to materialise given their partially self-defeating nature – especially for the European nations.
Last weekend Ukraine's President fled, following three months of street protests sparked by disputes over Ukraine's geopolitical orientation. Along with a political crisis, Ukraine now also faces an economic crisis that could culminate in a currency collapse and a debt default unless fresh external financing can be mobilised quickly. In the event that financing cannot be secured, the financial ripples could impact on the EU countries and Ukraine's eastern European neighbours including Russia. The consequences of a financial meltdown are sufficiently severe that some financing package will be agreed, but even in the event of fresh financing, downside risks to Ukrainian – and regional – growth have risen.
The general sell-off in emerging currencies that began in mid-January has paused in recent days, but in our view there remains a considerable danger of further bouts of weakness in the months ahead. Capital inflows to emerging markets are likely to remain subdued in the face of heightened concerns about country-level risks among the emerging countries, the continued sub-par growth performance of the BRICs and upward pressure on global interest rates due to US 'tapering'. This implies risks of renewed currency slippage in countries with weak fundamentals. Some countries such as Argentina and Venezuela appear to be on the brink of very large further devaluations, while countries with weak balance of payments positions and relatively unattractive asset returns such as Turkey, South Africa and Russia are also at risk.
Ongoing financial market turmoil has some observers fearing the worse. However, we view the risks to the US economy as relatively limited as long as the slowdown in emerging markets remains contained to a few countries. If, however, slower growth becomes pervasive across all emerging markets including China, then the risks to the US economy would become more significant. The recent Fed silence about global financial strains is surprising, but it may simply be a confirmation that isolated slowdowns in certain emerging markets do not pose a major risk to the US.
The ECB left rates unchanged at its February meeting and appeared relatively unconcerned about the risk of deflation. In our view, the ECB's inaction in the face of very low inflation and weak money and credit growth is worrying. The lack of action by the ECB is allowing the euro to remain strong, further raising the deflation risk – a scenario run on the Oxford Global Economic Model suggests that if the euro remains at current levels for the next two years, the Eurozone will come perilously close to deflation. Even a further interest rate cut may not be enough to ward off the deflation risk entirely, given that interest rates are already so close to the zero bound. The ECB needs to consider more radical options, including quantitative easing.
Emerging markets are being battered by another round of volatility as investors continue to withdraw capital. Many economies have experienced sharp exchange rate falls, particularly those considered most dependent on external capital, such as Turkey and South Africa. The immediate trigger for this latest round of risk on/risk off behaviour appears to have been a combination of (apparently) soft Chinese data and heightened political risks in eastern Europe, South America and Asia. Unlike the currency falls six months ago when the Fed first mooted tapering its quantitative easing, this time around US yields have been falling rather than rising – so by implication the risk premium for holding emerging markets is rising. We considered emerging market capital outflows to be one of the key risks to our forecasts in November, when we gave it a 10% chance of happening. Today that estimate looks conservative. The scenario would result in world growth falling to 2.4% this year, rather than our baseline forecast of 2.9%.
The uncertainty related to Argentina's FX policy continues, and recent policy directives have only fueled sustained depreciative pressures on the peso. We view such adjustments as a timid devaluation that will result in limited competitive advantages; and amid the continued lack of complementary policy process that targets inflation, deepening reserve losses, and ARS collapse threats are real.
In recent days, several emerging markets have been obliged to raise interest rates to try to stem downward pressure on currencies resulting from a combination of a reduced global risk appetite and the impact of US 'tapering'. This process may have some way to run, as real interest rates are still low or even negative in many major emerging countries. If investors are now demanding a significantly higher risk premium be paid to hold emerging assets, the emerging markets may face a sharp upward shock to domestic interest rates – perhaps a mini-version of the 'Volcker Shock' that hit the advanced economies in the early 1980s. This would have varied impacts across emerging markets depending on their vulnerability to higher interest rates. Interest rates have also risen in China, due to domestic rather than international factors. The effects of this are as yet uncertain but the potential risks are an increasing source of concern for investors.
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