Here, Richard Hoey, chief economist at BNY Mellon, gives a detailed commentary on the domestic US and international economic situation.
Editor's note: The following is commentary on the domestic US and international economic situation from Richard Hoey, chief economist at BNY Mellon. The article is republished with permission.
We believe that the world economy is in the mid-cycle phase of a sustainable global economic expansion. We expect cyclical expansion to be sustainable even as many economies experience a short sub-cycle slowdown in the industrial sector following the recent phase of an unsustainably rapid surge in industrial production at a time of higher energy prices and some policy tightening.
While global inflation pressures are rising, this is occurring after a period of disinflation. We expect a “sub-cycle inflation peak” later this year in many countries.
We believe that policy is unlikely to tighten enough—in either the developed countries or the emerging countries—to threaten the global expansion. Global macroeconomic policy remains stimulative. Some countries are shifting their policies from aggressively stimulative to stimulative and others are likely to shift from stimulative towards neutral. This is a normal pattern for the middle phase of a global economic recovery. While many emerging countries are expected to shift to policies that are less stimulative, we believe that hardly any are likely to reach a policy setting that will be restrictive enough to threaten sustained expansion.
There have been three recent supply shocks: (1) weather impacts on food production, (2) the decline in Libyan oil exports, and (3) the Japanese earthquake, tsunami and nuclear plant problems. It is clear that none of these were caused by monetary or fiscal policy. However, the macroeconomic policy context has remained relatively accommodative during the initial inflation surge resulting from these supply shocks. Excluding peripheral Europe, global economic policy has been stimulative for the last two years, so these supply shocks are occurring at a time of ample liquidity and continued global demand.
Some observers have noted that many of the post-war recessions have been preceded by oil price spikes. However, our view is that the global expansion should be sustained despite this oil price rise. We distinguish four phases in oil prices: (1) “cyclical normalization,” as oil prices rebounded from an unsustainable price near $30 per barrel during the recession to a more normal range of $75 to $85, (2) an additional demand-driven shift up to $90 to $95 in response to strong global economic growth led by the energy-intensive emerging markets, (3) an oil supply shock with oil prices rising above $100 due to the actual Libyan oil supply disruption combined with fears of other potential oil supply disruptions, and (4) a sharp recent pullback due to an unwind of commodity speculation after the combination of: (1) growing evidence of a sub-cycle slowdown in the industrial sector and (2) raised margin requirements on silver.
Higher oil prices do slow the growth in real incomes by driving up consumer price inflation. However, we believe that the two main reasons that oil price shocks have been followed by recessions in the past is that: (1) some oil price spikes have been caused by a much larger drop in the supply of oil, which forced a deeper decline in oil usage, and (2) prior oil price spikes have tended to trigger a shift to aggressively tight monetary policy as central banks fought inflation. Most prior oil supply shocks occurred when wage inflation and core inflation had already risen more substantially, motivating an aggressive tightening of monetary policy. In the current environment, many central banks have so far accommodated much of the short-term inflation shock.
In many emerging market countries, the initial settings of both currency policy and monetary policy were so stimulative that recent rate increases merely reflect less stimulative policy rather than a shift to aggressively tight monetary policy.
In the past, oil price shocks have tended to occur after many years of economic expansion at a time when broad financial liquidity had eroded and corporate balance sheets had become more leveraged. In contrast, the corporate sector worldwide is now flush with liquidity. Notably, the default rate for high yield bonds has been cyclically depressed as corporate cash flows have rebounded.
Refinancing opportunities are ample. There are some potential issues with European bank exposure to European peripheral risks, but the European authorities can be expected to manage these. Overall, we believe that in this cyclical context, the global corporate sector is relatively robust to shocks, including oil price shocks. Unless there is a large additional oil supply shock, we believe that there are low odds that high oil prices will trigger a recession.
Over the course of 2011, fluctuations in economic data due to temporary sub-cycle fluctuations may not provide reliable evidence of valid changes in the sustainable cyclical trends. Economic data is likely to reflect multiple economic patterns in three different time frames: (1) long-term secular trends, (2) sustainable cyclical trends, and (3) temporary subcycle fluctuations.
In our opinion, key long-term secular trends include: (1) faster growth in emerging market countries than in developed countries as emerging countries benefit from improved productivity by adopting modern technology, (2) increased commodity demand over time as real incomes rise in emerging countries, and (3) fiscal challenges in those countries with aging demographics, large entitlement programs and slowing trend growth.
We believe that key cyclical patterns in most countries will include: (1) sustainable economic growth (other than in peripheral Europe), (2) a slow upward drift in core inflation (inflation excluding food and energy), (3) a rising but volatile uptrend in reported inflation (inflation including food and energy), and (4) an upward trend in interest rates. In the US, we believe that there has been a transition to a cyclical trend of stronger payroll growth now that the average workweek has recovered and its rebound is no longer absorbing such a high proportion of the increased demand for labor.
Some important sub-cycle fluctuations we expect include: (1) a V-shaped pattern in the Japanese economy, (2) a drop and then a rebound in auto production, (3) a moderate sub-cycle cooling in the industrial sector in the next few months, and (4) an inflation surge with many countries likely to reach a “sub-cycle inflation peak” later this year. We expect reported inflation in 2012 to be lower than in 2011 in many countries even as core inflation continues to drift higher.
We expect a sharp sub-cycle pattern in the Japanese economy. It dropped at an extreme pace in the first several weeks after the earthquake and tsunami of 11 March 2011, with industrial production dropping 15.3 per cent in one month, an 86 per cent annualized rate of decline. We believe that Japanese industrial production and the Japanese economy have probably already bottomed. We expect the Japanese economic recovery to accelerate rapidly, especially once the electrical supply issues during the summer air conditioning season come to an end and rebuilding funds start to be released. The pace of recovery from late summer to year-end 2011 could be very rapid in Japan.
We expect a moderate sub-cycle cooling in industrial sector growth rates over the next several months, likely to be reflected in somewhat lower purchasing manager surveys in many parts of the world. The ratio of PMI orders to PMI inventories, a key leading indicator, has already weakened in a number of countries. The sharp rise in food and oil prices in recent months has contributed to a slowing of real income growth after a period of unsustainably rapid growth in industrial production, creating the preconditions for a moderate sub-cycle slowdown in the industrial sector. Later this year, we expect renewed strength in both real incomes and industrial sector activity, especially if oil prices stabilize at a high level rather than continue to trend substantially higher. That is what we expect.
We expect a temporary drop in auto production, especially in Japan and the US, due to a temporary disruption of the Japanese auto supply chain. New car inventories are likely to drop and auto prices rise.
Auto sales should weaken due to inadequate supplies rather than weak demand. As the auto supply food chain normalizes later this year, auto production and auto sales should rebound. Auto sales had only recently recovered to the trend level of auto scrappage and we expect renewed cyclical expansion of auto sales once the production disruption runs its course. We believe that many emerging countries have had macroeconomic policy settings which have been aggressively stimulative or stimulative.
Real interest rates have been low, interest rates have been low relative to nominal GDP growth rates, exchange rates have been undervalued and in some countries energy prices have been subsidized. A natural consequence has been strong real GDP growth, strong nominal GDP growth and rising inflation pressures. In response to persistent inflationary pressures, we expect policy tightening to occur in many emerging countries in the next several months.
We believe that the developed world is much less inflation-prone than are the emerging market countries. This is due in part to substantial excess capacity in the developed countries. In the US, we believe that “inflation normalization” is more likely than a sustained period of high inflation. As discussed below, we believe that the US currently has more of a “damp firewood” financial system than a “dry tinder” financial system, which implies only gradual strengthening of credit-financed spending.
While the ECB policy rate is low for Germany, we expect German long-term inflation expectations to remain well-anchored. Peripheral Europe has serious deflationary pressures, given fiscal austerity, high bond yields and a high euro. Japan may somewhat mitigate its deflationary trend but the odds of high inflation in Japan appear extremely remote. Fiscal austerity in the UK is so substantial that we believe that expectations that inflation will ease back down over the next year are likely to prove correct. It is important to distinguish between: (1) the level of monetary policy settings and (2) the change in monetary policy settings. Some emerging markets had very stimulative policies, with undervalued exchange rates, low real interest rates and subsidization of food and energy prices.
Policy normalization is beginning to occur as the inflationary consequences of these policies have become more apparent. But we believe that the basic story is that the setting of monetary policy is shifting only from stimulative to neutral, rather than to aggressively restrictive. Even this degree of reduced stimulation has begun to cool speculative excesses, but we believe that it is very unlikely to trigger a recession.
The Federal Reserve has been tolerant of a weak dollar under current cyclical circumstances. The Fed has a domestic dual mandate with respect to domestic inflation and domestic employment. It does not believe that it is responsible for the external store of value of the dollar, targeting only the domestic store of value by aiming for a moderate medium-term inflation rate. The US dollar has been weak in recent months because it was the US which had the severe housing bust. That meant that an easy monetary policy was more appropriate cyclically for the US than for many other countries.
The US can be expected to lag rather than lead the global uptrend in central bank policy rates. However, by the first half of 2012, we expect the Federal funds rate will begin to rise at a time when there is likely to be a pause in the uptrend in policy rates of other central banks. That should be more supportive of the dollar at that time. We believe that the main impact of QE2 was the announcement effect. The Fed signaled a “whatever it takes” commitment to avoid a double-dip recession. We believe that a secondary consequence of QE2 was to stimulate speculative sentiment at a time when the world was flush with excess financial liquidity. QE2 was preannounced by Chairman Bernanke on 27 August 2010. Much of what occurred since then was not necessarily caused by QE2, in our opinion. Our view is that the mid-2010 slowdown was largely attributable to temporary factors: (1) payback for the first time homebuyers’ credit, (2) an unsustainable flood of imports, and (3) uncertainty about tax and regulatory policies. The feared double-dip recession did not occur in 2010 and fears of a drop in profits also proved incorrect. As the optimistic case on sustained expansion and profit growth proved correct, the stock market moved higher. We believe that this growing confidence in higher corporate profits was the primary cause of the rise in the stock market. More recently, we believe that the markets have begun to discount the temporary sub-cycle slowdown in the industrial sector which we expect.
We make a distinction between gross monetary policy and net domestic monetary policy. Gross monetary policy is aggressively stimulative, indicated by: (1) a low real yield measured against core inflation, (2) a low real yield measured against reported inflation, (3) a low real yield measured against expected inflation, (4) a low natural rate of interest (nominal interest rate minus nominal GDP growth), (5) a steep yield curve, and (6) a weak dollar. Net domestic monetary policy is only mildly stimulative, once adjusted for the eroded debt capacity of households as well as the problems in the monetary and credit transmission mechanism.
Those who believe that massive excess reserves will generate a major acceleration of inflation have a “dry tinder” view of the monetary transmission mechanism, while we have a “damp firewood” view of the monetary transmission mechanism. While there are massive excess reserves in the US financial system, we do not believe that they will be quickly mobilized into credit and spending growth for three reasons. First, many consumers have negative housing equity, reduced net worth and/or low credit scores, so a lower level of interest rates has had only a limited effect in stimulating consumer and mortgage borrowing. Second, we believe that financial intermediaries are still somewhat risk averse.
Third, regardless of the views of financial intermediaries, financial regulation has been engaged in a major pro-cyclical regulatory tightening, offsetting much of the easy stance of gross monetary policy.
Adjusted for these factors, we regard net domestic monetary policy as only somewhat stimulative. We believe that the US financial sector is now in a “damp firewood” phase, not a “dry tinder” phase.
Under these circumstances, we believe that the US is more likely to face an “inflation normalization” in coming years, rather than any shift to sustained high inflation.
There has been a key debate among economists about whether continued deleveraging after the past credit boom would merely generate a subpar expansion or would substantially disrupt the expansion. We believe that the evidence has supported the case that deleveraging in the private sector would merely generate a subpar expansion but would not trigger a double-dip recession. In the US we interpret Federal Reserve policy as an attempt to engineer a “nominal fix” to reduce household debt-to-income ratios. If nominal GDP (real growth plus inflation) can compound at a normal 4 per cent to 5 per cent a year for the next five to ten years, debt-to-income ratios should improve, assuming there is a moderate pace of new household credit growth.
The US faces two different budget deficit problems: a short-term cyclical deficit problem and a long-term structural deficit problem. The short-term budget deficit reflects both: (1) the automatic impact of the recession on revenues and spending as well as (2) active fiscal stimulus via the passage of legislation which has increased Federal spending, cut taxes and postponed planned tax increases. The large short-term budget deficit is occurring in a context which makes it relatively easy to finance for now, given weak private sector credit demand and low interest rates.
However, we remain concerned about a potential for major fiscal problems in future years if the US continues to postpone a major reform of budget policy. The political right and the political left have a fundamental disagreement about the appropriate Federal spending share of GDP. Our most likely case is a succession of minor budget mini-deals over the coming years rather than a single grand compromise that solves the structural deficit problem. We believe that there is still a significant risk of a future fiscal train wreck, but it is most likely to occur four to seven years from now in a different cyclical environment (cyclically elevated core inflation, illiquid corporate sector, aggressively tight monetary policy). For now, we believe that the budget deficit is easy to finance and budget deficit stresses are unlikely to disrupt the cyclical expansion.