The Federal Reserve puts an end to normalization – My weekly column

The post is available in pdf format My Weekly Column – February 4

The US Federal Reserve decided to bring its monetary policy normalization to an end during its meetings on January 29 and 30, 2019.
The interest rate hike cycle had kicked off slowly in December 2015 and stepped up a pace a year later, as nine interest rate hikes pushed the Fed Funds rate up from 0.25% (upper end of range) to 2.5% in December 2018.
During last week’s press conference, the Fed Chair indicated that Fed Funds are now in the range of neutral, in response to the first question from journalists: there is no longer an accommodative or a tightening slant. Powell’s confidence in the strength of the US economy suggests that the end to normalization should not just be seen as hitting the pause button for a while.

The rate hike cycle has been long and slow-moving if we compare to the Fed’s previous series of tightening moves from 2004 for example. A comparison with this period also reveals that real interest rates on Fed funds were much higher then than they are now. The figure is currently marginally above the level witnessed at the start of the normalization process in December 2015, unlike the situation after 2004, when the economy was much more restricted, while this is not the case in the current economic situation.

A comparison of current real interest rates with previous phases of monetary tightening shows that today’s situation is completely different to these episodes.
Real interest rates in November 2018 stood at around 0.4% (inflation figures for December are not yet available on the PCE index), which is much lower than figures in 2006, 1999 or 1990. Does this mean that the US economy is too weak to be able to deal with a real rate above 1%? This would be extremely worrying and would undermine Jerome Powell’s comments that the US economy is in a good place.

It is difficult to understand why US normalization is coming to an end when we look at the economy, as unemployment is near its low, so the central bank should be tightening the reins. The Fed’s projections for 2019 and 2020 are for figures above the country’s potential growth rate and this also fits with the economists’ consensus, at least for 2019. Against this backdrop, monetary policy needs to be tighter to ensure that growth does not create imbalances that then have to be addressed, and this was the message from Powell in 2018, when he suggested that fiscal policy (too aggressive for an economy running on full employment) would need to be offset by tighter monetary policy to rebalance the policy mix. During the press conference on Wednesday January 30, he did not raise this question: the issue was side-stepped, but yet the analysis still remains the same. There are only two possible economic explanations for the halt to normalization: either there are expectations of a severe downgrade to projections when they are updated in March, but this would not be consistent with Powell’s comments; or the Fed is doing whatever it takes to extend the economic cycle at any cost, with the end to the rate hike cycle aimed at cutting back mortgage rates and taking the pressure off the real estate market. However, with the overall economy remaining robust, the risk of this type of move is that it could lead to imbalances that would be difficult to eliminate. This is the opposite approach to the Fed’s strategy right throughout 2018, so it would be a strange tactic.

The inevitable Chinese slowdown – My weekly column

This post is available in pdf format My Weekly Column – January 28th

Growth in China slowed again in 2018, with an average of 6.6% across the year vs. 6.9% in 2017.
This remains a respectable figure, but it is the lowest since 1989 and 1990 as shown in the chart opposite. The 10-year average is also at a low, at around 8%. The 10% that had previously been typical of the Chinese economy is now a thing of the past, and expectations of a shift back to this trend are unrealistic. The Chinese economy is changing, setting the stage for a slower pace of growth. 

A weighty challenge for the world as a whole
Slowing Chinese growth often sets off the warning bells on world growth as a whole. Having hinged on developed countries during the period after the Second World War, growth is now dependent on the situation in China, which has displayed exceptional expansion since the start of the 1990s, creating strong and long-lasting impetus for the world overall.

The world growth driver is now China, rather than developed markets, and this shift is particularly vital as potential growth in developed countries has been on the wane since 2008. Right across the globe, from the US to France, growth that can be sustained in the long term while not generating permanent imbalances is weaker than before the 2007 crisis, and none of these countries can drive strong and self-sustaining growth from within their borders. Meanwhile, China managed to fuel momentum, taking over the role of developed economies – particularly the US – and benefiting the entire world economy.

So China managed to set the stage for stronger growth the world over on a long-term basis, either by sparking fresh competition on the Western markets, developing relationships with other emerging countries (Asia, Africa, Latam) or attracting capital to take advantage of Chinese growth, even if the price to pay for this was the transfer of technology.

According to IMF data (in current dollars terms), Chinese GDP has gone from less than 2% of world GDP in 1991 to 6% ahead of the 2007 crisis and then 16% in 2018, reflecting an astounding acceleration and putting it on a par with the euro area.

Chinese GDP as measured in purchasing power parity – a more coherent price and exchange rate system than the dollar-denominated assessment – has been higher than the US figure since 2014 and above the euro area figure since 2011.

More generally speaking, an increase in the weighting of China was achieved primarily at the expense of Europe and Japan, while the US maintained its strong representation. This also explains why the tension surrounding technological leadership is a Chinese-US matter and excludes Europe, which was not sufficiently involved in supporting China’s swift development.

A final point worth keeping in mind is that Chinese imports equated to close to 80% of US imports in 2017. A domestic Chinese shock affecting its imports would have a similar effect to a shock on US domestic demand and hence on its imports, and the worldwide impact of a shock on Chinese growth would be closer than many would expect to the effects of a shock on US growth.

Why is the euro area slowing? My Weekly column

This post is available in pdf format My weekly column – January 15th

The euro area economy is slowing and could even see a contraction around the end of 2018 due to recessions in Germany and Italy, along with very weak momentum in France. The trend has changed at a faster pace than had been expected at the start of 2018, when the consensus was for similar trends to the very robust growth in 2017 i.e. no acceleration but continued swift economic growth. This pointed to expectations of more self-sustaining growth via jobs, income and investment, thereby driving a more independent trend that could safeguard some of the euro area’s economy against potential external shocks.
This quickening decline is worrying as the situation in a number of countries has gone from solid to shaky, for example Germany, where external trade is now hampering growth, along with Italy and France where domestic demand is no longer on the desired trend.
This quickening decline is worrying as the situation in a number of countries has gone from solid to shaky, for example Germany, where external trade is now hampering growth, along with Italy and France where domestic demand is no longer on the desired trend.

Why this perception of a swift deterioration in the euro area economy?
The first harbinger that all economic observers picked up on is the very swift deterioration in economic indices as measured by business leaders surveys. From a peak in the last quarter of 2017, the composite index slid swiftly and steadily right throughout 2018, failing to display a recovery. This trend is revealed in the euro area Markit manufacturing sector index, which slowed severely and sustainably in sync with world trade, with an accompanying drop in domestic and external orders.