Draghi outshines Yellen

by: Han de Jong

Big Picture - 25 August 2014 - Draghi outshines Yellen.pdf ()

The global financial community was holding its breath last week as Fed chair Janet Yellen was going to speak at the Jackson Hole conference on Friday. Draghi was also speaking at the conference, but less was expected of him. As it turned out, Draghi’s speech was the more surprising one. Yellen’s tone was perhaps a little less dovish than she has sounded in the past, but this is not a big surprise as US economic data has generally been better than expected in the US. Draghi, on the other hand, sounded much more prepared than in the past to take further action to support the economy and allow other policymakers to take further action as well. On balance, new stimulus by the ECB has become more likely, but we really have not got a lot more clarity on when the Fed will start raising interest rates, or on how aggressive their rate hikes will be. Meanwhile, the economy of the eurozone continues to disappoint as the US economy is starting to fire on all cylinders. I do not think that divergence will last. Expect eurozone indicators to get better before too long, possibly helped along by the ECB.

Yellen passed out on the inside by Draghi

All eyes were on Fed chair Janet Yellen last week as she spoke at the annual Jackson Hole conference. ECB boss Mario Draghi was also one of the speakers. While no fireworks were expected of him, his speech actually contained new elements. Draghi seemed to suggest that the ECB is more willing than the market considers likely to take more measures to prop up economic activity, reduce unemployment and prevent deflation. Draghi believes that the upcoming TLTRO programme will be very useful and an ABS purchase programme is a near certainty following Draghi’s speech. And if that is not enough, the ECB will consider doing more. Draghi also seemed to have changed his position a little on fiscal policy, arguing that fiscal policy should be used, within the existing framework of rules, to support demand. His call for structural reform was the only element that sounded very familiar with his earlier communication.

Janet Yellen’s speech at the Jackson Hole conference did not lead to major surprises. She observed that the labour market still has a lot of slack. This would suggest that she does not see any need for tighter monetary policy any time soon. But then, hardly anybody does. Most commentators do not expect rate increases much before the middle of next year. In a sense, that in itself is surprising. Official interest rates are close to zero, far below their ‘neutral rate’. At the same time inflation is at 2.0%, in line with the Fed’s mandate and unemployment is at 6.2%, which is above the Fed’s mandate, but is it really enough to justify interest rates being so much below their longer-term equilibrium? No one knows for sure. As the US economy has improved more strongly than expected in recent months, the views within the FOMC have shifted a little. The hawks have become louder and more numerous. Chair Yellen is generally seen as a dove, but she acknowledged the stronger data and noted that rate hikes could come earlier and be more aggressive than currently anticipated if the economy continues to improve more rapidly than expected. I think that was a sensible position to take for her. Markets reacted calmly. Bond yields move up a tick, the dollar strengthened a little and equity markets lost some ground, but that was following a two-week rally. At the end of the day, we did not get a lot of new insights. Our view remains that a stronger than expected economy will force the Fed’s hand eventually and that they will start hiking rates a little earlier than the market is pricing in. That does not mean that we think the Fed will hike rates soon or be particularly brutal about it. Apart from how strongly the economy will grow, the future path of interest rates will depend on how cyclical or how structural unemployment will turn out to be, how rapidly wages will increase in response to a tightening labour market and how much that will affect inflation.

Perhaps more interesting than Yellen’s speech was the meeting of the Bank of England’s Monetary Policy Committee last week. While the MPC voted to hold the Bank Rate at 0.5%, the vote was not unanimous. Two members voted for a rate hike. The UK economy has been recovering more strongly than others and has exceeded expectations. And the fact that two MPC members were willing to raise interest rates last week can be seen as an early indicator of tighter monetary policy in the UK. Markets also reacted calmly here, which was encouraging.

Divergence US – eurozone cannot last

I have commented in the recent past on the unusual divergence between US and European cyclical indicators. Last week saw more of the same: the US economy is starting to power ahead on all cylinders while Europe appears to be struggling. In addition, views on inflation in these two economies are also diverging. The discussion concerning inflation in the US is how fast inflation will rise, while the discussion about eurozone inflation is whether or not the economy will fall into deflation.

According to preliminary data from Markit, business activity in the eurozone weakened in August and it was below economists’ forecasts. The so called ‘manufacturing PMI’, which measures business activity in manufacturing, fell from 51.8 in July to 50.8. Compare that to the US reading on the same measure: 58.0 in August, up from 55.7 in July. Strong business activity in the US was corroborated by the Philly Fed index, which jumped from an already high 23.9 in July to 28.0. This was the strongest since 2011 and the second strongest since 2004. The ‘expectations’ component in this survey was actually the highest since 1992. These things can be volatile and they can fall back significantly again next month, but still… The residential construction sector is also seeing confidence strengthen as the NAHB sentiment index rose in August. Data on July housing starts and existing home sales showed renewed strength and the drop in the most recent number of initial jobless claims suggests that the labour market continues to improve.

Back to the eurozone. Consumer confidence weakened for a third consecutive month in August after having risen consistently since late 2012. Consumer confidence in the US has moved in the other direction. The conclusion is that these two economies are diverging and the question is if that will last. To my surprise, I do not see much commentary about how unusual this divergence of business cycles actually is. I am in danger of being repetitive as I have commented on this before, but it is a very important issue. Based on many years of observing cyclical patterns, I have three simple rules of thumb. First, the direction of the business cycle and the US and in Europe is highly correlated (even though the absolute level of growth can be very different). Second, if there is a lag between the two business cycles (which is not always the case), Europe lags, but the lag is not constant. And third, divergence between business cycles only occurs if one of these economies is hit by what economists call an a-symmetric shock. That means that divergence only occurs if one of these economies is impacted by a strong force that does not, or to a much lesser extent, affect the other. Examples of such a-symmetric shocks are German unification in 1989 and the eurozone’s sovereign debt crisis in 2011. Under current circumstances, I cannot see what should push the eurozone economy back into stagnation or worse. Neither fiscal policy nor monetary policy are so different suddenly that either of them should drive a wedge between these two economies. The crisis in Ukraine is an obvious factor that is more important to the eurozone than to the US economy, but our estimate is that the effects on the economy are most likely to be limited.

My colleague Nick Kounis commented twice last week on the disappointing eurozone data. He showed that the past strength of the euro is a factor at play here. He also showed that the drag caused by the currency should soon fade.

Then there are some other factors that can be involved. The mild winter in Europe boosted activity in Q1, leading to payback in Q2. There were also fewer working days in Q2 in the eurozone, which could have had an effect. Then there is the inventory cycle. In some countries the corporate sector managed to build up inventory levels before Q2, but stopped doing that in Q2. This is a temporary effect.

My overall conclusion remains the same here. It is true that eurozone economic indicators have disappointed lately. However, I consider it unlikely that this would be the beginning of another extended soft patch or something worse. I think there is no good explanation for sustained eurozone weakness against a background of accelerating growth in the US and stable growth in emerging economies. It just does not make sense. In my view, it is inevitable that eurozone cyclical indicators will improve before too long. Having said that, I think the ECB is right in becoming more aggressive. The risks are skewed to the downside and the ECB cannot take those risks.