Global economy – How uncertainty begets more certainty

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This post is a guest contribution by Joachim Fels of Morgan Stanley.

Spanners in the works. Our reasonably constructive outlook for the global economy in 2H11 is being seriously challenged by two recent events – the surprisingly weak US labour market report and the spreading of the euro area debt crisis to Italy, the third-largest government bond market in the world. While the lack of labour market improvement in recent months throws doubt on the expected rebound in US economic activity this and next quarter, the worsening debt crisis could make even our below-consensus forecast for European growth in 2H11 and 2012 look wildly optimistic.

US markdown. To be clear, we continue to look for a rebound in US growth during 2H11, driven by a rebound in auto production, relief for the consumer from lower gasoline prices, stronger capex due to tax incentives and US re-industrialization, and support from net exports. However, several of these factors are technical or temporary by nature, and the apparent lack of labour support in recent months has induced our US team to mark down its GDP growth forecast for 2H11 to 3.5% from nearly 4% last month.

Fiscal policy uncertainty. Moreover, uncertainty about the 2012 US outlook remains very high as much will depend on the course of fiscal policy, where there is a wide range of possible outcomes at this stage. On current policies, the expiration of tax relief for companies and households would lead to a significant automatic tightening of fiscal policy early next year. Yet, the recent weak economic performance might help build momentum for other measures aimed at boosting employment and an extension of the current tax relief, probably coupled with a last-minute compromise on the debt ceiling.

Below consensus, but still too optimistic? In Europe, our base case has already been a significant slowing of the euro area economy in 2H11 and 2012, reflecting slower global trade momentum, past euro appreciation, a less supportive ECB and peripheral fiscal tightening. Note that this scenario was based on the assumption that governments would succeed in kicking the proverbial can further down the road, thus containing, though not resolving, the sovereign debt crisis.

Too large to rescue. However, the recent spreading of the debt crisis to Italy, the euro area’s third-largest economy and the third-largest government bond market in the world, has significantly increased the stakes for policy-makers. Italy is not too large to fail, but in our view, it is too large to rescue, if this ever became necessary. We expect a combination of Italian fiscal austerity measures to be finalised soon and additional euro area-wide measures such as an agreement on a second Greek rescue package and an increase in the scope and flexibility of the EFSF, possibly coupled with a reopening of the ECB’s bond purchase programme, to help contain the crisis. We are mindful, however, of the high and rising risk that severe policy divisions between and within the euro area governments prevent agreement on such stop-gap measures, which would raise the spectre of a much larger crisis, recession and, potentially, a break-up of the euro.

Central banks accommodative for longer. Yet, the more uncertain the growth outlook in the US and Europe, the more likely it becomes that central banks in both regions – and elsewhere – keep policy accommodative for longer. This is the only certainty in all the uncertainty. Indeed, in his Testimony to Congress today, Fed Chairman Bernanke emphasised that “the economy still requires a good deal of support” and even discussed potential measures that the Fed might take if growth disappoints:

“The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally.”

ECB may change its tune. Meanwhile, the ECB Council continued to sound hawkish and prepared to raise rates at least once more in the statement and press conference accompanying last week’s rate hike. However, with the debt crisis intensifying since then, implying a market-based tightening of monetary conditions for a large part of the euro area including Italy, further rate hikes look less likely now than they did a week ago. Much of the rate outlook will depend on whether governments manage to come up with a stop-gap as discussed above.

EM: From tightening to easing? Moreover, uncertainty about growth and sovereign debt in the DM world is also likely to make EM central banks reconsider their policy stance faster. Even before the recent events, our view has been that policy tightening in the EM world is coming to an end as inflation looks likely to have peaked for now and the soft landing in China seems to be at hand. A more uncertain growth outlook for the US and Europe is likely to accelerate this process and may even lead to a faster swing from tightening to easing in China as policy-makers are keen to protect growth.

Liquidity cycle alive and kicking. Against this backdrop, global monetary conditions are likely to stay easy for longer, with real policy rates remaining in negative territory in many countries. As a consequence, the global liquidity cycle is likely to remain alive and kicking, and the recent dip in our preferred measure of excess liquidity – global money supply M1 relative to nominal GDP – should prove to be temporary.

‘Nominal’ rather than ‘real’ solutions. Taking a step back, the recent events and likely policy responses lend support to our view that the developed world is heading for a ‘nominal’ rather than a ‘real’ solution to its problems. Governments’ apparent inability to come to grips with the long-run fiscal policy issues in Europe and the US, together with the uncertainties surrounding the growth outlook, are forcing central banks to keep the spigots open for longer. This makes an inflationary global outcome in the next several years more and more likely. However, a good dose of inflation may be exactly what the doctor ordered for a highly indebted developed world. As the 1930s and Japan have taught us, the opposite would be much worse in many respects.

Source: Joachim Fels, Morgan Stanley, July 15, 2011.

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