Macro Weekly – Difficult times

by: Han de Jong

Big Picture - 19 October 2014 - Difficult times.pdf ()

These are clearly difficult times for participants in financial markets. And they are also problematic for policymakers. The crisis has triggered an unprecedented policy response, and it is no surprise that policymakers are learning all sorts of lessons along the way. It seems to me that they have recently misfired and shot themselves in the foot a few times. I believe policymakers will draw lessons and the economic recovery will gain some momentum into 2015.

A lesson for Mr Samaras

The Greek Prime Minister has suggested that he would like to end Greece’s IMF programme, and rely fully on funding in financial markets instead. The IMF’s response was that Greece should not end its adjustment programme. The market’s response was a deafening rejection of this idea. Ten year yields on Greek government bonds had been moving in a band of 5.5%-6.5%, but shot up to 9% last Thursday. That seems a clear message to me that the market is telling the Greek government not to end the IMF programme. To what extent they will listen is another matter. They could try to get the Greek banks to buy government bonds and borrow from the ECB. The domestic political situation in Greece is complicated, of course. The anti-bailout Syriza party is ahead in the polls and is trying to force early elections. So Mr Samaras may have seen a political advantage in ending the programme.

Doubting your own success. Why?

The mood in global financial markets had been subdued following weak economic data in the eurozone when the IMF held its annual meeting in Washington last week. Probably in an effort to increase the sense of urgency for reform policies, IMF officials stressed the downside risks, in particular for the eurozone. IMF boss Christine Lagarde went so far as to say that the eurozone is facing a 40% chance of sinking into a new recession. That did not exactly lift the mood, to put it mildly. While I would not want to suggest that it is the IMF’s job to be unrealistically optimistic in order to ‘talk up’ the economy, neither can I see any point in talking the economy down unnecessarily. And it seems to me, that is exactly what she has done. The global recovery is fragile and, arguably, the biggest risk to the recovery is a loss of confidence. Policymakers have pulled out all the stops in recent years to get the economy back on its feet and some success can certainly be claimed. Why would they now doubt that so explicitly and put their own success at risk? The question is, of course, whether Lagarde is right with her 40% recession risk. I cannot see it. Given how low (potential) growth is in the eurozone, it is always possible to have two consecutive quarters of mildly negative growth, but what I mean is that a prolonged period of significant decline of activity seems extremely unlikely. Serious recessions don’t appear out of nowhere. They are caused by something. Apart from loss of confidence, the most obvious suspects for causing a recession are overly tight monetary policy, very restrictive fiscal policy, a sharp rise in inflation, a sharp rise in oil prices, a collapse of asset prices or some other sort of shock. Lack of reform in France and Italy is not going to cause a recession in the eurozone – they are nothing new. As I have argued before, I see the eurozone gradually enjoying a number of tailwinds: the lower euro, fallen borrowing costs, lower oil prices and the gradual healing of the credit channel as shown by the ECB’s bank lending survey. By making the ‘40% remark’, Lagarde seems to have exposed the economy to the most important risk.

Has Mr Draghi overplayed his hand?

Commentators concluded that the ECB is on its way to sovereign QE (quantitative easing) from Mr Draghi’s speech at the Jackson Hole conference some weeks ago. He has so far failed to live up to these expectations. I think it is difficult for the ECB to engage in such a strategy as there are legal and political hurdles. Therefore, I think Draghi may have overplayed his hand a little. Another issue with central bankers is that they have recently demonstrated quite a number of differences of opinion within their own ranks. Normally that does not matter, but when confidence is vulnerable, disunity among central bankers is not helpful

The right price for risk

Policymakers have recently also warned of excessive asset prices with several of them pointing out that investors may be too complacent and may be underestimating risk. Sovereign spreads in the eurozone would appear a case in point, and over the last couple of days spreads on peripheral bonds have widened out considerably. In this area, too, one has to wonder what policymakers are trying to achieve. They have done what they can to prevent a break-up of the euro. So it is not surprising that investors consider that risk very low. Policymakers have also demonstrated that they would not like to see another sovereign debt write down in the eurozone, following the debacle of the Greek debt write down in 2011. It would seem that they have convinced market participants of that also. So I would say that the very tight spreads on peripheral bonds over German bonds are a sign of success on the part of the policymakers. They have convinced investors that the risk of another debt write-down is small and the risk of a break-up of the euro is even smaller. If these events have a very low probability, is it really surprising that spreads are tight? By arguing that that investors are complacent, are policymakers actually saying that they themselves may ultimately not be successful? Isn’t that an odd message? We are not sure how exactly quantitative easing (QE) of monetary policy works. Most analysts distinguish between different channels. QE is meant to push borrowing costs down and lead to portfolio shifts with investors. So, boosting asset prices, aiming for an improvement in confidence and positive wealth effects is all part of the plan. It seems very odd to me for policymakers to then openly question if this has gone too far. If this is the case, then reverse the policy.

A major inconsistency

I see another major inconsistency in overall policy. On the one hand, in their role as prudential supervisors, policymakers are trying to get households and the financial sector to reduce risks. Buffers must be strengthened and risky activities ended. This process puts a lid on economic growth. Meanwhile, monetary policy is aggressively trying to work in the other direction. This is all well and good, but it means that people are encouraged to reduce risks while they are also encouraged to increase risk. It is like driving a car while stepping on the brakes and the accelerator at the same time. You fail your driving test if you do that. The result, I think, is a potential for excessive risk aversion in the real economy and excessive risk appetite in the financial economy. That looks to me to be a recipe for instability.

Last week’s data

Economic data was a little volatile last week. Eurozone industrial production fell 1.8% mom in August and fell 1.9% yoy in August. This was not a good result, but was largely driven by Germany. We knew a week earlier that German output had fallen by more than 4% in August. This was partly blamed on a different pattern of holidays. The European data gives some credence to that view as Germany really was the odd one out. According to Eurostat, output fell 0.1% mom in France, but rose in Italy, Spain and the Netherlands by 0.3%, 0.1% and 1.3%, respectively. The ZEW index, measuring analysts’ confidence fell again in October, both for the eurozone as well as for Germany. That is not good, but it might in this case be a lagging indicator and simply a response to recent disappointing data and stock market volatility. Recent dat from various airports is more encouraging. True, freight data published by Fraport, the body that runs Frankfurt airport, is weak. But freight volume in Schiphol is up 4% yoy in September, while Spain is up 14% yoy. The trend for all airports continues to be up. News in the US was better. Early on in the week, disappointing retail sales for September and a poor reading on the so-called Empire State index – a business confidence gauge in the district of the New York Fed – had added to market gloom. But initial jobless claims fell to the lowest level in over 14 years, a sign of continued improvement on the labour market. The Philly Fed index of business confidence in the Philadelphia Fed district did not confirm the New York’s equivalent and declined only marginally in October, staying at a high level. US industrial production grew strongly in September (1.0% mom), pushing the yoy rate to 4.3%. Finally, Chinese data was not too bad either. Export and import growth improved noticeably in September and money and credit data is suggesting that the targeted stimulus measures are taking effect. Overall, we maintain an optimistic view on the global, including eurozone, outlook. The economic recovery is set to continue and gain momentum into 2015. (Eurozone) policymakers are facing some challenges and, in my personal opinion, they haven’t always made the right choices, particularly in their communication. But I think they will, eventually, address further challenges successfully.   141019-tabel