All industrialized countries currently have very low inflation and interest rates. When central banks hint at increasing rates, the effects are considerable, especially for the Fed. This is typical of high credit and liquidity driven markets: the quantity of funds looking for returns creates speculative ups and downs globally and within countries, in stocks, bonds, currencies, and all other markets. Income inequality adds to the picture, because the propensity to save (and invest in financial markets) is very high for high income earners. The quick reaction to rumors of “normalizing rates” by central banks creates immediate stress in markets and could affect the real economy through tighter credit and financial market returns. Are we all living on artificial boosting like an athlete on steroids? Let’s look into this a bit more...
The global economy now and going forward
To helps put things in perspective, here is a snapshot of the current situation in a few selected countries:
I want to focus on the industrialized countries for this post. So... what do we make of this general picture for the industrialized economies?
Labor markets are very different, which reflects policy differences that cause major divergences in growth and material well-being in the long run: a low natural unemployment rate, a high employment rate, innovation and productivity.
The fact that interest rates are at zero means that if there were to be a slowdown or recession in any country, barring major fiscal expansion, the immediate macro policy tool would be to print money, or “quantitative easing” to boost financial asset prices and keep yields low.
Strangely, even with all the stimulus we have had and still have with fiscal positions showing significant deficits, zero interest rates, and a fair amount of QE, we still have this fuzzy feeling that the world economy is on constant brink of tipping back into recession, and this time with much less macro policy options due to already-high public debt and already-low interest rates.
“Mini recessions” and macro policies
When you go over growth rates and other macro variables for the G20 economies, you notice an interesting fact: there was an “almost recession” or an outright recession for almost all of them between 2010 and now, many in 2012-2013. We did almost tip into global recession since 2010, but the huge stimulus support prevented it. Is this apparent need for stimulus a probelm? Well, as many honest answers to such questions seem to be, the answer is... it depends on the point of view!
The fact that economies seem to require monetary stimulus makes some (Freshwaters) say that we are in a “fake growth world” and that we are obviously doomed, since we can’t grow at reasonable rates without huge stimulus and eternally expanding debt-to-GDP ratios. They claim that the stagnation of many is due to broken structural policies (tax structure, labor market regulation and structure, institutions, etc) and that the natural value creation mechanism of a decentralized economy needs to be restored by letting production and exchange happen more naturally and freely. They also criticize monetary expansion for creating asst bubbles that only make things worse down the road.
Others (Saltwaters) agree with the other group about the basics of long run growth and prosperity, but they say that as long as you don’t have inflation issues or public debt disasters, there is no real problem and we should just go ahead and use macro policies to close the output gap and maintain full employment to avoid hysterisis and prolongued destructive stagnation.
These seemingly childish differences of opinion matter, because major institutions that affect growth and unemployment have a bias towards one or the other. I would dare say that the Fed has a Saltwater bias (not surprizing considering Yellen’s CV and social circle) and the ECB has a Freshwater bias.
Do we have a major problem? I will cut the debate short and say this: those that can sustain their fiscal dynamics for the next decade (regardless of debt and other considerations) and have no inflation should not worry about stimulus, as long as their structural policies create incentives for job creation, growth, and innovation. Period. USA, Germany, UK, Canada, Australia, Netherlands, Switzerland. Others simply can’t go on with such horrible labor market conditions and will eventually have to do “something” about the long run growth outlook (i.e. structural policy changes). France, Italy, Spain.
There is still MUCH more capital floating around than what is being absorbed by the real economy. This means that financial markets are flooded with liquidity (global savings + central bank money), which creates volatility (and lots of financial opportunities for those who understand markets well!). Unless governments launch major spending programs, I do not see this situation changing any time soon.
Getting out of zero inflation
Inflation rates around the industrialized world are supposed to fluctuate roughly between 1% and 3%. We are not there at all. A student in my International Economics class told me “it seems that monetary expansion no longer creates inflation, if we look at all the printing and compare that to inflation.” I answered “inflation is much higher than it otherwise would be.”
In other words, if it were not for expansionary monetary policies, the whole world would be in deflation and debt-deflation dynamics. We are not. Monetary expansion does create inflation. If you want inflation, you get it. I guarantee. The fact that we have zero inflation is a choice, even if it doesn’t seem that way.
One thing seems obvious to me and has been for a while, which explains my shorting of the Euro in the past months: the USA will tighten before the ECB! (note: this now seems fully priced in, so I exited my position recently... Just saying).
Another thing seems clear: it is a QE world, with all that comes with it. Why? Because when rates are so close to zero and inflation is essentially nowhere to be seen, monetary stimulus comes mostly in the form of printing, or “quantitative easing.”
To get out of zero inflation, we need 2 things: a zero or slightly positive output gap and more monetary expansion. Now not all countries need stimulus, which brings us to the important discussion of macro policies going forward, and their impacts on markets (including forex).
The strategic puzzle of the Fed
Will the Fed start hiking rates? This must be a big dilemma for Janet Yellen. Tighten now and risk roiling domestic and global markets, even with a very modest move. Keep rates low and risk excessive credit expansion, bubbles, maybe over-expansion in 2017-2018, and more importantly, a future recession while rates are at zero. The Fed’s problem is that the corporate profit outlook is not great right now, and a rate hike would not help. Since profits are a leading indicator to production and employment during recoveries and expansion, the Fed must be hesitating on what to do and more importantly, the words to use when they communicate their policy decisions (even when not changing the rate).
It seems clear that of all major industrialized monetary zones, the USA is in somewhat better shape, which implies tighter policy going forward and a stronger USD, all else equal. That said, this must constantly be reassessed every now and then, as well as how much of this is currently priced in for those who trade in stocks, forex, and all other financial markets. Public debt is a non issue for the short and medium run for the USA.
The ECB and the Euro
Although Germany is doing well, it has issues of export dependance. The ECB is stuck with very different economic situations between the Eurozone countries. Once the Brexit issue is cleared up (in one way or the other), if Eurozone stagnation and deflation keeps a strong hold on the short to medium run outlook, the ECB will have no choice but to move more aggressively. Public debt is a major issue for some non negligeable Eurozone players, which complicates things a bit.
The biggest economy of the Eurozone (Germany) is at potential, but still zero inflation. Others are probably in negative gap and in deflation. There was massive QE, yet obviously not enough to get out of deflation dynamics. Will the orthodox ECB really open the monetary valves after mid June? We’ll see, but if so, there will be massive currency action worldwide! Keep your eyes open!
Bank of Japan Schizophrenia
As you know, Japan is stuck in deflation and has been for quite some time. The issue for the Bank of Japan is that if it fights deflation with printing, it runs into 3 considerable problems:
Quite a bind! You can’t print to re-inflate due to massive global forex pressure on the currency; you have limited options to spend due to excessive public debt; you can’t increase rates due to the threat of the debt service exploding; you have a limited growth outlook due to demographics... I am not sure myself what to make of all this, to be honest. What are the options here? I would say they boil down to this:
There may be others, but one thing seems clear to me: Japan has quite a complex context! It must be hard (but interesting) to be a policy maker in Japan... but this situation is ripe for plenty of forex profit for those who understand the macro financial picture!
Bank of England and Brexit
The UK situation resembles the US context in some regards: unemployment close to the natural rate, very low inflation, close to zero bank rate. The main issue for the very short run is Brexit, which influences all currency pairs in forex. Any way it goes, the unclear picture creates risk. I personally got out of all positions until after the UK membership thing is cleared, in one way or another.
Once the EU membership is known (any way it goes), we will be able to see clearly for appropriate strategies in all markets. But again, there is no inflation pressure, so no hurry for rate hikes... unless the Pound comes under pressure, which will pose a hard dilemma for the Bank of England... a replay of the 1990s?
Bank of Canada Eternal Warnings
The Bank of Canada has been “warning” about “excessive household debt” and credit expansion for many years, yet has kept interest rates very low. The crowd yawns. Some fall asleep. Warnings and hand waiving matter not for small economies. Of course you can’t really increase rates with a recession (2015 mini recession) and current slowdown. This being obvious to anyone who cares to look at data for 5 minutes, we all disregard BOC talk about household debt: they keep rates low and they probably have no choice, which of course creates credit expansion. So what?
Although inflation picked up in 2015-2016 due to lagged effects of the CAD depreciation, there is little fundamental inflationary pressure in Canada. A significant rate hike campaign seems unlikely for now. Fiscal expansion of the new government will sustain growth at the margin, but the stimulus is relatively mild and was entirely priced in the CAD very quickly. There is no public debt problem in Canada, so simply disregard any calls for panic.
The Canadian context has marginally created some household debt systemic risk, putting pressure on the otherwise solid Canadian banking sector. We will see how all this unfolds in the coming 6 to 12 months. This year will be quite interesting...
Are we hooked on stimulus like drug addicts?
The neutral interest rate was negative since 2008 for most economies and probably very close to zero now, and still negative for some economies. This means that 1% could be “high” due to the neutral rate. We would be hooked on stimulus if we had inflation spirals: stimulate to decrease unemployment, which generates inflation problems and changes inflation expectations, etc. A 1970s style thing. We are not there at ALL.
We just have this illusion that i = 0% is “low”, which of course is totally arbitrary. Maybe it is “normal” now, with 35 years of disinflation AND the arrival of massive global savings since the turn of the century. The issue is that we can’t go very negative due to cash hoarding that would cause quite a few problems for banks and central banks.
Of course the real challenge is to generate growth and prosperity beyond fiscal and monetary stimulus, which boils down to incentives to produce and innovate, create jobs and productivity growth.
For what it is worth, my 2 cents is that almost all industrialized economies should massively de-tax corporations and all forms of production and rethink taxation in a bold way. How you tax is probably much more important for growth and prosperity than how much you tax. The devil is in the details.
But my opinion and call for policies is of no importance for financial strategies in stocks, forex, and more. What matters for financial investments is to keep the macro financial picture in mind when you look at your charts, price action, and indicators, and finally decide on your positions and the time horizon for your strategies, as well as the policy risks involved.
No inflation and rates at zero. Some countries have quite a dilemma, especially Japan. Otherwise the global context is clear, even with all the noise and complexities. The only country that has some room to tighten is the USA, but for now they have a soft patch and global markets very reactive to any form of Fed talk or moves.
Be ready for lots of financial market action in the coming year, from stocks to bonds and currencies – plenty of risk, plenty of opportunity!
Growth and prosperity are not dead at all. We simply have low inflation and rates in many places. But the global economy still steams ahead, with a historically low global poverty rate, improving macro policies in emerging market economies, lots of research and innovation that are ripe to help with significant global environmental challenges, and a growing global middle class in emerging markets.
Rich countries have some issues, but we have seen much more daunting challenges, and beyond the cynical calls of many a skeptics, policy makers in the rich world are very competent and they know what they are doing. Politicians sometimes make us wonder if they have any clue at all about what makes for healthy growth and prosperity, but that is nothing new and seems to be impoving at least a bit. What is more worrisome is entire countries asking for broken policies, but in the end, I think common sense and “aggregate intelligence” gains ground.
Markets will keep offering opportunities for those with the power of knowledge. Keep following us at YourPersonalEconomist, and you will have an edge.
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