Thursday, October 12, 2017

Likely economic scenarios for the next few years ahead

"For the past few years, the global economy has been oscillating between periods of acceleration (when growth is positive and strengthening) and periods of deceleration (when growth is positive but weakening). After more than a year of acceleration, is the world heading towards another slowdown, or will the recovery persist?

The current upswing in growth and equity markets has been going strong since the summer of 2016. Despite a brief hiccup after the Brexit vote, the acceleration endured not only Donald Trump’s election as US president but the heightening policy uncertainty and geopolitical chaos that he has generated. In response to this apparent resilience, the International Monetary Fund, which in recent years had characterised global growth as the “new mediocre”, upgraded its World Economic Outlook in July.

Will the recent growth spurt continue over the next few years? Or is the world experiencing a temporary cyclical upswing that will soon be subdued by new tail risks, such as those that have triggered other slowdowns in recent years? It is enough to recall the summer of 2015 and early 2016, when investors’ fears of a Chinese hard landing, an excessively fast exit from zero policy rates by the US Federal Reserve, a stall in US GDP growth and low oil prices conspired to undercut growth.

One can envision three possible scenarios for the global economy in the next three years or so. In the bullish scenario, the world’s four largest, systemically important economies – China, the eurozone, Japan and the US – implement structural reforms that increase potential growth and address financial vulnerabilities. By ensuring that the cyclical upswing is associated with stronger potential and actual growth, such efforts would produce robust GDP growth, low but moderately rising inflation and relative financial stability for many more years. US and global equity markets would reach new heights, justified by stronger fundamentals.

In the bearish scenario, the opposite happens: the world’s major economies fail to implement structural reforms that raise potential growth. Rather than using the national congress of the Chinese Communist party this month as a catalyst for reform, China kicks the can down the road, continuing on a path of excessive leverage and overcapacity. The eurozone fails to achieve greater integration, while political constraints limit national policymakers’ ability to implement growth-enhancing structural reforms. And Japan remains stuck on its low-growth trajectory, as supply-side reforms and trade liberalisation – the third “arrow” of Shinzo Abe’s economic strategy – fizzle out.

As for the US, the Trump administration, in this scenario, continues to pursue a policy approach, including a tax cut that overwhelmingly favours the rich, trade protectionism and migration restrictions, which may well reduce potential growth. Excessive fiscal stimulus leads to runaway deficits and debt, which results in higher interest rates and a stronger dollar, further weakening growth. Trigger-happy Trump could even end up in a military conflict with North Korea, and, later Iran, diminishing US economic prospects further.

In this scenario, the lack of reform in major economies will leave the cyclical upswing constrained by low trend growth. If potential growth remains low, easy monetary and credit policies could eventually lead to goods and/or asset inflation, eventually causing an economic slowdown – and possibly an outright recession and financial crisis – when asset bubbles burst or inflation rises.

The third and in my view most likely scenario lies somewhere between the first two. The cyclical upswing in growth and equity markets continues for a while, driven by the remaining tailwinds. Yet, while major economies pursue some structural reforms to improve potential growth, the pace of change is much slower, and the scope more modest, than is needed to maximise potential.

In China, this muddle-through scenario means doing just enough to avoid a hard landing, but not enough to achieve a truly soft one; with financial vulnerabilities left unaddressed, distress becomes all but inevitable over time. In the eurozone, this scenario would entail only nominal progress towards greater integration, with Germany’s continued rejection of true risk-sharing or fiscal union weakening incentives for struggling member countries to undertake tough reforms. In Japan, an increasingly ineffective Abe administration would implement minimal reforms, leaving potential growth stuck below 1%.

In the US, Trump’s presidency would remain volatile and ineffective, with a growing number of Americans realising that, despite his populist pretence, Trump is merely a plutocrat protecting the interests of the rich. Inequality rises, the middle classes stagnate, wages barely grow and consumption and growth remain anaemic at barely close to 2%.

But the risks of muddling through extend far beyond mediocre economic performance. This scenario represents not a stable equilibrium, but an unstable disequilibrium, vulnerable to economic, financial and geopolitical shocks. When such shocks eventually emerge, the economy will be tipped into a slowdown or, if the shock is large enough, even recession and financial crisis.

In other words, if the world does simply muddle through, as seems likely, it could, within three or four years, face a more bearish outlook. The lesson is clear: either political leaders and policymakers demonstrate the leadership needed to secure a better medium-term outlook, or downside risks will materialise before long – and do serious damage to the global economy."

via guardian

Thursday, September 7, 2017

Tuesday, August 8, 2017

Restricting Immigration to the US could hurt Economic Growth in the USA


Now that US President Donald Trump has been in office for six months, we can more confidently assess the prospects for the US economy and economic policy making under his administration. And, like Trump’s presidency more generally, paradoxes abound.

The main puzzle is the disconnect between the performance of financial markets and the real. While stock markets continue to reach new highs, the US economy grew at an average rate of just 2% in the first half of 2017 – slower growth than under President Barack Obama – and is not expected to perform much better for the rest of the year.

Stock-market investors continue to hold out hope that Trump can push through policies to stimulate growth and increase corporate profits. Moreover, sluggish wage growth implies that inflation is not reaching the US Federal Reserve’s target rate, which means that the Fed will have to normalize interest rates more slowly than expected.

Lower long-term interest rates and a weaker dollar are good news for US stock markets, and Trump’s pro-business agenda is still good for individual stocks in principle, even if the air has been let out of the so-called Trump reflation trade. And there is now less reason to worry that a massive fiscal-stimulus program will push up the dollar and force the Fed to raise rates. In view of the Trump administration’s political ineffectiveness, it is safe to assume that if there is any stimulus at all, it will be smaller than expected.

The administration’s inability to execute on the economic-policy front is unlikely to change. Congressional Republicans’ attempts to replace the Affordable Care Act (Obamacare) have failed, not least because moderate Republicans refused to vote for a bill that would deprive some 20 million Americans of their health insurance.

The Trump administration is now moving on to tax reform, which will be just as hard, if not harder, to enact. Earlier tax-reform proposals had anticipated savings from the repeal of Obamacare, and from a proposed “border adjustment tax” that has since been abandoned.

That leaves congressional Republicans with little room for maneuver. Because the US Senate’s budget-reconciliation rules require all tax cuts to be revenue-neutral after ten years, Republicans will either have to cut tax rates by far less than they had originally intended, or settle for temporary and limited tax cuts that aren’t paid for.

To benefit American workers and spur economic growth, tax reforms need to increase the burden on the rich, and provide relief to workers and the middle class. But Trump’s proposals would do the opposite: depending on which plan you look at, 80-90% of the benefits would go to the top 10% of the income distribution.

More to the point, US corporations aren’t hoarding trillions of dollars in cash and refusing to make capital investments because the tax rate is too high, as Trump and congressional Republicans claim. Rather, firms are less inclined to invest because slow wage growth is depressing consumption, and thus overall economic growth.

Beyond tax reform, Trump’s plan to stimulate short-term growth through $1 trillion in infrastructure spending is still not on the horizon. And, instead of direct government investment of that amount, the administration wants to provide modest tax incentives for the private sector to spearhead various projects. Unfortunately, it will take more than tax breaks to bring large infrastructure projects from start to finish, and “shovel-ready” projects are few and far between.

On trade, there is good news and bad news. The good news is that the administration has not pursued radically protectionist policies, such as branding countries as currency manipulators, introducing across-the-board tariffs, or pushing for the border adjustment tax.

The bad news is that Trump is sticking to his “buy American, hire American” credo, and his protectionist gestures will hurt growth more than they save jobs. He has already abandoned the Trans-Pacific Partnership and negotiations for the Transatlantic Trade and Investment Partnership with the European Union. He is renegotiating the North American Free Trade Agreement, and he may try to renegotiate other free-trade agreements, such as the bilateral deal with South Korea. And he could still start a trade war with China by introducing tariffs on steel and other products – especially now that China has been uncooperative in responding to North Korea’s escalating nuclear threat.

Trump could also limit the US’s growth potential by restricting immigration. In addition to barring visitors from six predominantly Muslim countries, the administration is intent on restricting migration for high-skill workers, and is ramping up deportations of undocumented immigrants. This, along with the much-ballyhooed border wall, will cut future labor supply, and thus economic growth, especially as the American population continues to age and drop out of the labor force.

Lastly, Trump’s deregulation agenda will not boost economic growth, and may actually weaken it over time. If financial regulations are loosened too much, the result could be another asset and credit bubble, and even another financial crisis and recession.

Meanwhile, Trump’s decision to withdraw from the Paris climate agreement, combined with a rollback of environmental regulations, will lead to ecological degradation and slower growth in green-economy industries such as solar power. And weaker labor protections will further reduce workers’ bargaining power, thus holding down wage growth and overall consumption.

It is little wonder that actual and potential growth is stuck at around 2%. Yes, inflation is low, and corporate profits and stock markets are soaring. But the gap between Wall Street and Main Street is widening. High market valuations that are fueled by liquidity and irrational exuberance do not reflect fundamental economic realities. An eventual market correction is inevitable. The only question is whom Trump will blame when it happens.

Monday, July 24, 2017

Why QE and other Unconventional Monetary Policies will be used again

Financial markets are starting to get rattled by the winding down of unconventional monetary policies in many advanced economies. Soon enough, the Bank of Japan(BOJ) and the Swiss National Bank(SNB) will be the only central banks still maintaining unconventional monetary policies for the long term.

The US Federal Reserve started phasing out its asset-purchase programme (quantitative easing, or QE) in 2014, and began normalising interest rates in late 2015. And the European Central Bank is now pondering just how fast to taper its own QE policy in 2018, and when to start phasing out negative interest rates, too.

Similarly, the Bank of England (BoE) has finished its latest round of QE — which it launched after the Brexit referendum last June — and is considering hiking interest rates. And the Bank of Canada (BOC) and the Reserve Bank of Australia (RBA) have both signalled that interest-rate hikes will be forthcoming.
Still, all of these central banks will have to reintroduce unconventional monetary policies if another recession or financial crisis occurs. Consider the Fed, which is in a stronger position than any other central bank to depart from unconventional monetary policies. Even if its normalisation policy is successful in bringing interest rates back to an equilibrium level, that level will be no higher than 3 per cent.

It is worth remembering that in the Fed’s previous two tightening cycles, the equilibrium rate was 6.5 per cent and 5.25 per cent, respectively. When the global financial crisis and ensuing recession hit in 2007-09, the Fed cut its policy rate from 5.25 per cent to 0 per cent. When that still did not boost the economy, the Fed began to pursue unconventional monetary policies, by launching QE for the first time.


As the last few monetary-policy cycles have shown, even if the Fed can get the equilibrium rate back to 3 per cent before the next recession hits, it still will not have enough room to manoeuvre effectively. Interest-rate cuts will run into the zero lower bound before they can have a meaningful impact on the economy. And when that happens, the Fed and other major central banks will be left with just four options, each with its own costs and benefits.
First, central banks could restore quantitative- or credit-easing policies, by purchasing long-term government bonds or private assets to increase liquidity and encourage lending. But by vastly expanding central banks’ balance-sheets, QE is hardly costless or risk-free.

Second, central banks could return to negative policy rates, as the ECB, BOJ, SNB, and some other central banks have done, in addition to quantitative and credit easing, in recent years. But negative interest rates impose costs on savers and banks, which are then passed on to customers.

Third, central banks could change their target rate of inflation from 2 per cent to, say, 4 per cent. The Fed and other central banks are informally exploring this option now, because it could increase the equilibrium interest rate to 5-6 per cent, and reduce the risk of hitting the zero lower bound in another recession.
Yet this option is controversial for a few reasons. Central banks are already struggling to achieve a 2 per cent inflation rate. To reach a target of 4 per cent inflation, they might have to implement even more unconventional monetary policies over an even longer period of time.

Moreover, central banks should not assume that revising inflation expectations from 2 per cent to 4 per cent would go smoothly. When inflation was allowed to drift from 2 per cent to 4 per cent in the 1970's, inflation expectations became unanchored altogether, and price growth far exceeded 4 per cent.

The last option for central banks is to lower the inflation target from 2 per cent to, say, 0 per cent, as the Bank for International Settlements has advised. A lower inflation target would alleviate the need for unconventional policies when rates are close to 0 per cent and inflation is still below 2 per cent.
But most central banks have their reasons for not pursuing such a strategy. For starters, zero inflation and persistent periods of deflation — when the target is 0 per cent and inflation is below target — may lead to debt deflation. If the real (inflation-adjusted) value of nominal debts increases, more debtors could fall into bankruptcy.

Moreover, in small, open economies, a 0 per cent target could strengthen the currency, and raise production and wage costs for domestic exporters and import-competing sectors.

Ultimately, when the next recession strikes, central banks in advanced economies will have no choice but to plumb the zero lower bound once again while they choose among four unappealing options. The choices they make will depend on how they weigh the risks of bloating their balance-sheets, imposing costs on banks and consumers, pursuing possibly unattainable inflation targets, and hurting debtors and producers at home.

In other words, central banks will have to confront the same policy dilemmas that attended the global financial crisis, including the “choice” of whether to pursue unconventional monetary policies. Given that financial push is bound to come to economic shove once again, unconventional monetary policies, it would seem, are here to stay.


via projectsyndicate

Tuesday, July 11, 2017

What the Central Banks will do in the next Recession

Financial markets are starting to get rattled by the winding down of unconventional monetary policies in many advanced economies. Soon enough, the Bank of Japan (BOJ) and the Swiss National Bank (SNB) will be the only central banks still maintaining unconventional monetary policies for the long term.

The US Federal Reserve started phasing out its asset-purchase program (quantitative easing, or QE) in 2014, and began normalizing interest rates in late 2015. And the European Central Bank is now pondering just how fast to taper its own QE policy in 2018, and when to start phasing out negative interest rates, too.

Similarly, the Bank of England (BoE) has finished its latest round of QE – which it launched after the Brexit referendum last June – and is considering hiking interest rates. And the Bank of Canada (BOC) and the Reserve Bank of Australia (RBA) have both signaled that interest-rate hikes will be forthcoming.

Still, all of these central banks will have to reintroduce unconventional monetary policies if another recession or financial crisis occurs. Consider the Fed, which is in a stronger position than any other central bank to depart from unconventional monetary policies. Even if its normalization policy is successful in bringing interest rates back to an equilibrium level, that level will be no higher than 3%.

It is worth remembering that in the Fed’s previous two tightening cycles, the equilibrium rate was 6.5% and 5.25%, respectively. When the global financial crisis and ensuing recession hit in 2007-2009, the Fed cut its policy rate from 5.25% to 0%. When that still did not boost the economy, the Fed began to pursue unconventional monetary policies, by launching QE for the first time.

As the last few monetary-policy cycles have shown, even if the Fed can get the equilibrium rate back to 3% before the next recession hits, it still will not have enough room to maneuver effectively. 

Interest-rate cuts will run into the zero lower bound before they can have a meaningful impact on the economy. And when that happens, the Fed and other major central banks will be left with just four options, each with its own costs and benefits.

First, central banks could restore quantitative- or credit-easing policies, by purchasing long-term government bonds or private assets to increase liquidity and encourage lending. But by vastly expanding central banks’ balance sheets, QE is hardly costless or risk-free.

Second, central banks could return to negative policy rates, as the ECB, BOJ, SNB, and some other central banks have done, in addition to quantitative and credit easing, in recent years. But negative interest rates impose costs on savers and banks, which are then passed on to customers.

Third, central banks could change their target rate of inflation from 2% to, say, 4%. The Fed and other central banks are informally exploring this option now, because it could increase the equilibrium interest rate to 5-6%, and reduce the risk of hitting the zero lower bound in another recession.

Yet this option is controversial for a few reasons. Central banks are already struggling to achieve a 2% inflation rate. To reach a target of 4% inflation, they might have to implement even more unconventional monetary policies over an even longer period of time. Moreover, central banks should not assume that revising inflation expectations from 2% to 4% would go smoothly. When inflation was allowed to drift from 2% to 4% in the 1970s, inflation expectations became unanchored altogether, and price growth far exceeded 4%.

The last option for central banks is to lower the inflation target from 2% to, say, 0%, as the Bank for International Settlements has advised. A lower inflation target would alleviate the need for unconventional policies when rates are close to 0% and inflation is still below 2%.

But most central banks have their reasons for not pursuing such a strategy. For starters, zero inflation and persistent periods of deflation – when the target is 0% and inflation is below target – may lead to debt deflation. If the real (inflation-adjusted) value of nominal debts increases, more debtors could fall into bankruptcy. Moreover, in small, open economies, a 0% target could strengthen the currency, and raise production and wage costs for domestic exporters and import-competing sectors.

Ultimately, when the next recession strikes, central banks in advanced economies will have no choice but to plumb the zero lower bound once again while they choose among four unappealing options. The choices they make will depend on how they weigh the risks of bloating their balance sheets, imposing costs on banks and consumers, pursuing possibly unattainable inflation targets, and hurting debtors and producers at home.

In other words, central banks will have to confront the same policy dilemmas that attended the global financial crisis, including the “choice” of whether to pursue unconventional monetary policies. Given that financial push is bound to come to economic shove once again, unconventional monetary policies, it would seem, are here to stay.