Macro Weekly – I am getting confused

by: Han de Jong

When I look at the world economy, I see reasonable growth and signs of strengthening momentum across a wide range of countries. I also see inflation at very modest levels, below the formal targets of central banks in key economies, but no deflation. That is an encouraging picture. And yet, everybody is talking about providing stimulus. The Trump policy agenda in the US is expected to provide a boost to activity and the ECB has just extended its asset purchasing programme by nine months, even though it announced a reduction of the monthly purchases as of March next year.

Macro-Weekly-9-December-2016.pdf (90 KB)

On the one hand, these stimulus measures are starting to look unnecessary. On the other hand, history shows, in my view, that ending stimulus too soon causes bigger problems than ending it a little late.

Just take a look at recent economic indicators and the dilemma gets clearer. Recent trading days saw strong growth of industrial orders in Germany in October (though weak output growth). US durable goods orders were also solid in November, the US labour market is continuing to tighten and business confidence in the US services sector improved strongly in November. Chinese trade data underscore the positive trends seen elsewhere. Export growth and import growth weakened significantly in the course of 2015; export and import values actually declined. But an improvement has set in in the course of 2016 and continued strongly in November. Looking at this type of activity data, you would not think the economy is in need of a lot of policy support or of additional stimulus.


Other data shed a somewhat different light. Inflation is low in most countries, also in countries with solid growth and labour markets. Core inflation in the eurozone has been stuck near its current level of 0.8% for some time and is well below the ECB target (though, admitted, that is for headline inflation) of ‘below, but close to 2%’. The US Fed’s favourite inflation measure, core PCE inflation has also been relatively stable this year around the current level of 1.7%. As inflation continues to be low, the risk of deflation in the case of a negative shock is still significant. Meanwhile, inflation expectations have risen. In the US this started around the middle of the year, but accelerated sharply in November after the US elections. Europe was lagging behind a little with the upward trend in inflation expectations starting in September. In the past, the rise or fall in inflation expectations has often been closely linked to oil prices. This time, that relationship does not appear to dominate. So expectations are rising for a different reason and hawks suggest that it provides another reason for central banks to tighten.

Bear in mind, however, expectations are only expectations. They can become self-fulfilling prophecies if they lead to changed behaviour, particularly in the wage bargaining process. That would be welcome. So far, however, there is little evidence of that, especially in Europe. If inflation pressures fail to build, inflation expectations could easily come down again. In the European case, the ECB would be taking a gamble if it stopped or started tapering its asset purchase programme soon.

The ECB may have had another consideration in mind when they extended their QE programme until the end of 2017. ECB officials will not admit to this, but 2017 could lead to political change that might cause unrest in financial markets. It would look very bad if the ECB ended its stimulus now only to be pulled back into buying securities in the course of 2017. Better to let the programme run at least until the Dutch, French and German elections are out of the way.

Many critics of ECB policy argue that ‘bubbles are everywhere’ and when they pop, as bubbles inevitably must, the damage will be significant. I cannot say I agree with that. Yes, bond yields are extremely low, but, surely, so is the ‘natural interest rate’, we must assume. Bond yields will rise over time, but it does not seem likely that they can or will rise massively even after central banks stop buying bonds. If that expectation turns out to be correct, it is hard to argue that the bond market represents a huge bubble. Other assets also do not appear excessively valued. Equities are certainly not cheap, but they are much cheaper than, for example, during the tech bubble around the turn of the century.

Another indicator published recently to keep an eye on in my view is Chinese FX reserves. They fell in November by almost USD 70 bn, the largest monthly drop since January. It is hard to assess the drivers of the drop. Valuation effects may have played a role as the dollar strengthened in November. But changes in Chinese FX reserves have, in the past, been a good indicator of financial conditions in emerging economies at large. A significant capital outflow from emerging economies is a risk to financial stability globally.

All in all, I am encouraged by recent economic data globally. Economic growth is gaining momentum, while inflation is low and increasing only modestly. This favourable picture raises questions over stimulus measures. At least for now, I think that policy makers are correct in continuing their policies.