Fra BNP Paribas:
One of the contributory factors to the (recently improved) malaise in markets has been doubts over the effectiveness of policy.
From a monetary-policy perspective, this relates not only to a perceived lack of ammunition, but also to question marks over the potency of what is available. Unconventional measures appear to suffer from diminishing returns, and even in the economies where large-scale asset purchases were introduced ‘early’, there has not yet been a sustained turnaround in inflation or inflation expectations.
An additional dimension to this is a lack of coordination, both across the central banks and in terms of more joined-up thinking when it comes to using all policy levers. Regarding the former, the G20 meeting of finance ministers and central-bank heads on 26-27 February is an obvious focal point. It is not obvious, though, that there will be much change, in part because the interests may not be sufficiently well aligned.
From a currency perspective, for example, the ECB and Bank of Japan appear to favour ‘beggar thy neighbour’ policies centred on negative interest rates, while the Fed is increasingly concerned about the tightening of US and global financial conditions resulting from USD strength.
The electoral timetable in the US is also an issue when it comes to Chinese currency depreciation. So while concerted action may be desirable in theory, it looks difficult to achieve in practice, at least in short order. The legacy of past coordination is also a consideration. Monetary easing in Japan in response to JPY appreciation after the Plaza Accord generated a massive stock and real-estate bubble.
A similar accord now to buy time for China to transition to a floating exchange rate and the prolongation of super-low interest rates in the US could foster even bigger asset-price bubbles. The second issue, a lack of joined-up use of policy levers, has been a recurring feature of the speeches from ECB President Mario Draghi. His call for action in “all policy areas” was stepped up a gear in his recent address to the European Parliament.
While he reiterated that the ECB “is ready to do its part”, he said it is “becoming clearer and clearer that fiscal policies should support the economic recovery”, along with the familiar call for reforms. The fiscal stance in the eurozone this year should be moderately expansionary – a change from the years of cross-country austerity. It is small in scale, though. On our estimates, the primary balance, once adjusted for the cycle, will fall by around 0.4% of GDP this year from 2015. The fiscal compact reduces eurozone members’ options when responding to possible adverse shocks, especially for high-debt countries.
The European Commission has warned both Portugal and Spain that their draft budgets for 2016 are at risk of violating the Stability and Growth Pact. A negotiation is under way with Italy, meanwhile, on the potential for more flexibility in fiscal policy. An opinion from the Commission on the issue is expected in May. The risk is that the Commission will reject part of Italy’s request for greater flexibility and require it to implement significant fiscal consolidation in 2017. Given external headwinds, growth in the eurozone is likely to disappoint the assumptions underlying most national budgets. As a result, fiscal targets will probably be overshot.
This will be mainly through fiscal stabilisers, however, as there is very limited room for fiscal policy to play an anticyclical role through structural changes to the budget position. A more flexible approach could be allowed in exchange for more reforms, but the prospects for the latter are limited. The political climate in many European countries is not helpful in this regard. Rising support for populist/protest parties has altered the political landscape and the wind of change is blowing against the supply-side policies the ECB is calling for. What about elsewhere?
In the US, the FOMC meeting minutes for January included a statement that “monetary policy was less well positioned to respond effectively to shocks”. The staff for the Board of Governors took it one step further, saying that fiscal policy is also not well positioned to help the economy withstand substantial adverse shocks. These comments came on the back of a more negative assessment of the balance of risks facing the economy.
In our view, while we are still quite a few steps away from the Fed reaching its limits (forward guidance, policy-rate cuts, QE), the ammunition is limited. In responding to recessions over the last 50 years, the Fed has had to ease at least 500bp via the fed funds rate to get the economy back on track. While interest rates could go sub-zero in the US (and most likely will), they probably will not go too far into the red, leaving the Fed with only 100bp or so on this front.
It would take a whole lot of QE, particularly with its diminishing returns, to have the same impact as another 400bp in policy easing. Politically, meanwhile, the US elections continue to be riddled with uncertainty. The election of Republican front-runner Donald Trump, without many backers in his own party, could prove to be a very uncertain path for fiscal policy, which could imply very few changes. Meanwhile, the Democrat frontrunner, Hillary Clinton, looks unlikely to shake up the fiscal landscape significantly if elected. Fiscal deficits remain near their 20-year lows, so there is some fiscal space available, but it would take a real crisis to get Congress on board with a stimulus package.
As in Europe, significantly easier fiscal policy would probably only follow an equally significant deterioration in economic prospects. In Japan, the government is still in the midst of the budget deliberations for FY2016 and contends, in public, that it still believes in the fundamental strength of the economy. However, with Q4 GDP printing a negative reading and the introduction of negative interest rates having utterly failed to reverse yen appreciation, the authorities must surely be becoming deeply concerned about the outlook. Once the budget-deliberation process ends next month, the government is highly likely to start discussing extra fiscal actions.
With the upper-house election set to take place in July, the government could well decide to have an extra budget in addition to the one compiled in January. A further postponement of the VAT hike scheduled for April 2017 is also a distinct possibility, in our view. Such a decision would surely lead to further downgrades of Japanese government bonds, which would cause collateral damage to funding costs of Japanese corporates and banks.
But with the cost of borrowing for the government now effectively at zero, policymakers might be tempted to kick the can down the road yet again. In China, with the effect of monetary easing diminished, fiscal policy is expected to play a bigger role in stemming growth deceleration and facilitating economic restructuring. Fiscal-revenue growth looks set to dwindle further due to slower growth, however, along with prospective cuts in taxes and administered prices as a key ingredient of supply-side reforms. Meanwhile, decent expenditure growth will have to be maintained to finance infrastructure investment as well as to provide unemployment subsides. We expect a larger official fiscal deficit, therefore, equivalent to 3.1% of GDP for 2016 (versus 2.4% last year).
In addition, the ‘stealth’ deficit is set to continue to grow via borrowings of local-government financing vehicles. The spike in new lending in January was driven by strong demand from these vehicles to boost growth. As such, the leverage ratio and indebtedness of the Chinese government will keep increasing. In other countries, too, the outlook is challenging. In Russia, for example, there is an ongoing deep recession and almost no room for monetary easing, but fiscal-policy stimulus would not be effective in triggering a recovery, either. Instead, an increase in highly inefficient government spending would probably only exacerbate the problem of structurally high inflation.
Any fiscal stimulus would be appropriate only after inflation is brought down close to the central bank’s 4% target, which is unlikely in the coming years, in our view. Furthermore, collapsing oil prices have made the whole discussion a purely theoretical one: amid difficult market conditions, the government is reluctant to increase still low public debt and has been trying hard to contain the widening budget deficit (likely to exceed 5% of GDP this year).
In Latin America, Mexico’s central bank reminded us of the power of conventional monetary policy with a surprise intra-meeting 50bp policy rate hike. By abruptly increasing the policy rate to 3.75%, it temporarily de-linked from the Fed in an effort to calm the FX market and reduce the risk of higher inflation due to FX-pass through. In recognising the limits of monetary policy, Mexico’s Exchange Rate Commission suspended its USD auction programme and set the stage for discretionary interventions in the FX market.
