The world economy is looking increasingly surreal, so much so that policymakers are really struggling to deliver the economic outcomes they’d ideally like to see.
The usual rules of the game no longer seem to apply. Long before oil prices tumbled in the second half of last year, inflation was coming in persistently lower than expected. Once confined only to the textbooks and Japan, deflation has become a major headache for central bankers across an ever-increasing number of countries.
World trade growth, meanwhile, has been disappointingly weak. Some of this is doubtless cyclical, reflecting historically low growth rates across the US, the eurozone and China. Yet there is also evidence to suggest that some of the weakness is structural, associated with, for example, shifts in global value chains, an increase in protectionist measures and less generous trade finance.
Put these two factors together and it’s no surprise that many central banks still have an easing bias. Some are attempting to export home-grown deflation elsewhere via currency depreciation.
Others increasingly fear a collapse in inflationary expectations that could threaten negative effects both within the financial system and across labour markets more broadly.
Yet a persistent easing bias is leading to some odd effects. Equity prices have continued to soar even as bond yields have plunged: are we heading for a sustained boom (as equity prices might suggest) or are we heading into another depression (as bond yields in many parts of the world might be indicating)?
Meanwhile, in the world of monetary policy, we are all too quickly entering a Dali-esque world in which oddities abound. Most obviously – and seemingly inconsistent with the analysis contained within countless university tomes – we are now witnessing the proliferation of negative nominal interest rates.
In part, this doubtless reflects growing fears within the investment community about so-called fat-tail risks in a world where little conventional policy ammunition is left to deal with, for example, the onset of another global recession.
Yet there is something fundamentally disconcerting about the arrival of negative nominal interest rates. The longer they persist – and the lower they go – the bigger the risk of a fundamental shift in the operation of the financial system. In the initial stages, we may already be on the verge of witnessing restrictions on the provision of bank credit. Further out, it is just possible to imagine a world in which cash is king, where money is stored in vast warehouses, and where we return to a world not so dissimilar to that which prevailed under the Gold Standard. Central bankers should be careful what they wish for.
While the commitment to keep the monetary sluice gates open is alive and well in many parts of both the developed and the emerging world, the Federal Reserve is, in effect, the elephant in the room. Even though global growth is weak, world trade growth is slow and deflationary pressures abound, the Fed is much more focused on domestic US economic developments.
After six years of sustained – if modest – economic recovery and with a faster-than-expected decline in unemployment, it’s increasingly clear that the Fed is pondering on exactly when to pull the interest rate trigger.
In our view, it would be wise for the Fed to exercise caution. US forecasters are typically an optimistic bunch but, since 2000, that optimism has rarely been justified: in most years, outcomes have been lower than expected. Wage growth remains remarkably muted given the decline in unemployment. And US export growth was very weak even before the dollar’s recent rapid ascent, a reflection of the aforementioned weakness in world trade growth.
The danger with a possibly premature interest rate increase is that it might be followed at a later stage by an embarrassing reversal: that, after all, was the experience of the ECB and Swedish Riksbank in 2011, the Bank of Japan in 2000 and, for students of history, the Federal Reserve itself in 1937.
Following our interim forecast update at the beginning of February – in response to further oil price declines – we have made only modest changes to our forecasts on this occasion. India is stronger, largely thanks to a change in methodology by Indian statisticians. The US is a touch weaker, a view seemingly shared by the FOMC following the publication of updated projections from the Fed on March 18.
The eurozone, helped along by a weaker euro and a lower oil price, is a little stronger. On the inflation front, our biggest revisions are in the emerging world: Brazil and Russia have bucked the global trend, facing ever-greater domestic inflationary pressures, but China is now reinforcing the global trend, with inflation there now likely to average only a little over one per cent this year.
Meanwhile, on the currency front, it may be that the US dollar rally – like the US economy – may finally be running out of steam.
Stephen King is the chief global economist, HSBC Bank plc.