Governments against the euro zone

Christine Lagarde, in her first official speech as President of the ECB, called for the implementation of a new policy mix to allow the Eurozone to develop all its growth and employment potential. The complementarity between fiscal and monetary policy should, according to the new President of the ECB, allow such a scenario. The Eurozone could then have more growth autonomy and a greater capacity to decide for itself.

Christine Lagarde will have to be convincing because governments do not take the demands of the central bank seriously.
Mario Draghi, before her, had already, and from the beginning of his mandate, called for a rebalancing of economic policies. The request of Christine Lagarde shows that the former President of the ECB has never been listened to or taken into account.
Draghi committed to a strategy of low interest rates to improve the public finances solvency. By pushing interest rates down, he facilitated more aggressive fiscal policies and structural reforms to improve the growth profile of the Eurozone economy.. Governments have never engaged on this point.

The ECB has, since the arrival of Mario Draghi, carried out an accommodative monetary policy. In the summer of 2012 the ECB became the lender of last resort of the Euro Area, thus guaranteeing the safeguarding of the banking and financial system. It then lowered policy rates to around 0% and then launched its QE in March 2015. All these unorthodox policies have been criticized from all sides as being excessive and in no way boosting growth or inflation.

How could it have done when the fiscal policy of the Euro zone is restrictive since 2011? The structural primary surplus (i.e. corrected for cyclical effects) since 2012 reflects a fiscal drag. In no case has there been fiscal stimulus at the euro area level since 2010 (the data are calculated by the IMF and a larger deficit reflects a fiscal stimulus).
At the time, 2008/2009, the collapse of the economy had caused this large public deficit. But as soon as growth resumed, with the revival of the G20 decided in London in April 2009, Europeans have become systematically restrictive again. The ECB then played the same role as the Commission, helping to accentuate the six-quarter recession in the Eurozone.

The Eurozone fiscal policy has never been conducive to supporting activity and enhancing growth.
The primary fiscal surplus has been around 1% of potential GDP since 2013 and has not moved since. The rigor implemented in 2011/2012, which resulted in the very long recession, was never questioned. The budget texts put in place in 2013 to signal the seriousness of the budget options and to reassure the financial markets have not, in fact, helped to strengthen growth in the Eurozone.

One may wonder whether accommodative monetary policy has not been the pretext for not adopting a proactive fiscal policy. Another interpretation, monetary policy became frankly accommodating only because Draghi had the perception that governments and the Commission would never let go on fiscal policy. Since the ECB adopted a strategy to support growth, it was no longer necessary to do so at the Eurozone level.
Draghi has allowed governments not to reform, not to promote growth, to criticize the inefficiency of monetary policy with impunity while being able to complain about populist excesses.

Will Christine Lagarde fall into the same trap as Draghi?

What to expect this week – 18 November – 24 November 2019

Highlights

> —Minutes of the last Fed’s meeting (Nov. 20) and of the last ECB’s meeting (Nov.21)
The Fed’s minutes will reveal the discussions on the drop of the Fed’s benchmark rate but the most useful part will be on the commitment to stop, at least temporarily, the downside trend on the benchmark rate.
In the ECB minutes, the focus will be on the discussions related to the important disagreements between governing council members after September decisions —

> Markit flash estimates for November in the Euro Area, Japan and the US (Nov.22)
In October a rebound in the US for the manufacturing sector was a surprise reflecting mainly the spike in the New export Orders index. The divergence with the eurozone and Japan was astonishing. The November survey will highlight the possibility for the US to remain strong while Japan and the EA are still weak.  —

> The French Climat des Affaires for November (Nov. 21)
The French index has been above its historical average for months. This is consistent with the stronger momentum of the French growth when compared with the Euro Area. This is linked to the specificity of the French economic policy that feed domestic demand in order to cushion a possible external shock. This strategy limits the possibility of a downturn.

> Eurozone Current Account for September (Nov.19)
The Euro Area current account shows a large surplus. It is circa 3% of GDP. This means that there is an excess saving in the Euro Area and that we have means to invest in order to improve the autonomy of our growth process. Because accumulating surplus is just useless.

> Existing homes sales in the US for October (Nov. 21) and Housing Starts (Nov.19)
Existing home sales indicator is a measure of a wealth effect on consumption expenditures. Its recent profile suggests a slowdown in expenditures during the last quarter of this year before a mild rebound at the beginning of 2020. —

> Productivity in the third quarter for the United Kingdom (Nov. 20)
The strong slowdown in the UK productivity suggests an extended period of low growth except if investment rebounds strongly. This will not be the case whatever the Brexit agreement because Brexit will continue to provide large uncertainty. —

> The Phylli Fed index will be release on November the 21st. The Japanese trade balance on November the 20th, the Japanese CPI for October on November the 22nd and the German Consumer Confidence index on November the 21st  

The Fed lowers its benchmark rate but stop there

The Fed lowers its benchmark rate to 1.5-1.75%. It says it wants to take a break. It downplayed expectations of another cut this year. The three drops this year are consistent with the September dots’ graph. Now the real rate of the fed is negative while the unemployment rate is at 3.5%. Always a very strange configuration.

We are waiting for the press conference to find out what Powell will say about the money market, which is not stabilizing. There is a real concern.

On this latter point, the message from Powell was clear. Stay away, it is not your business. It’s a bit scary, isn’t it ?

What to expect this week (October 28 – November 3)

Highlights

> The Fed’s meeting with a press conference and a press release on Wednesday. Two questions: are disagreements between FOMC members remain as high as in September ? Will the Fed cut its target rate ? The dots graph suggests a third cut this year.

Christine Lagarde will replace Mario Draghi as president of the ECB next Friday. The balance between politics and economics will be different than in the current mandate. The main task for Christine Lagarde will be to maintain the cohesion of the ECB members at a moment where the monetary policy is already very accommodative and the impact of a change will be questioned and lower than in the past.

On the Brexit side, a vote is expected today on the possibility of general elections on December the 12th  Boris Johnson will probably not have the qualified majority for it.
The EU, in a draft, has proposed an extension of the Brexit until the end of next January.

> GDP figures will be released this week in the US and in France (30) and in the Euro Area, Italy and Spain (31). Expectations are on lower figures than in the second quarter. This would be consistent with the business surveys seen during this third quarter.

> ISM index for the manufacturing sector (November 1) will be key to anticipate the business cycle profile in the US. The index was below the 50 threshold in August and September.

> The Chinese official PMI index (31) and the Markit index for the manufacturing sector (1st )

> The Markit indices for the manufacturing sector will be released on November the 1sr except on Continental Europe.

The US employment report next Friday. The momentum is lower than in the first part of the year even with a very low unemployment rate

Inflation flash estimates will be released in Europe this week. (Euro Area 31). As the oil price is on average lower than in September (53.7 € in October vs 56.7€ in September )  and has to be compared with a high level in October 2018 (70.3€). The energy contribution will be strongly negative and the inflation rate will be probably below the 0.8% seen in September.

The document is available here
NextWeek-October28-November3-2019

nwoct28

Some thoughts on US monetary policy*

The US central bank – the Federal Reserve – has trimmed its key interest rate again, marking a further step forward down a new track. Its monetary policy is now developed independently of the US economic situation, as the Fed’s strategy is dictated by worldwide uncertainty that could hit the domestic economy and push it off its current robust path. Uncertainty on world trade, the impact of the administration’s trade policy and concerns on world growth are all prompting the Fed to adjust it strategy.

In the past, the country usually adopted a more accommodative stance in response to a sharp economic slowdown. In 2007/2008, the Fed changed its policy when liquidity dried up on the money market, but this was the exception rather than the rule, with the Fed only reacting to changes in the US economy with little concern for the rest of the world. This approach was only natural as world trends at the time were dictated by the US.

Fed backtracks after rate hikes in 2018

This shift in focus raises a number of points:
The Fed is backtracking after its upward trend in 2018, when it raised its key rate four times. These were the right moves at the time as the White House had implemented a very aggressive fiscal policy at a time when the economy was close to full employment, so it was vital to keep on a lid on tension that could have surged and dented the economy.
This rearrangement in the economic policy balance was perfectly plausible given economic conditions.
However, fiscal policy was not as effective as expected, and made a smaller contribution to driving the economy than anticipated, so the Fed no longer needed to continue its monetary tightening policy.
The outlook changed when the international context became more risky, particularly as a result of US trade policy.
The combination of these two factors prompted the Fed to maintain the status quo, then start easing, with a very clear timeline: on January 30, 2019 the Fed hit the pause button, then started easing on July 31, and again on September 18. Its policy is now highly accommodative as the real Fed Funds rate is only very slightly positive.

The US policy mix is now very accommodative, while the economic cycle is at a peak

It is interesting to take a closer look at economy policy measurements. The US policy mix is now very accommodative at a time when the country is still at the peak of the economic cycle. The public deficit stands at $1,000bn (almost 5% of GDP) and the real Fed Funds rate is only just slightly positive. Well might we wonder how the Fed will steer economic policy in the event of a shock on growth – can we expect an even bigger public deficit and should we anticipate negative interest rates from the Fed?

We could well think that the Fed rushed to change its accommodative strategy due to this unfortunate combination, as the economy is still robust and does not require monetary stimulus. It is also still very closed to outside influences, with trends and activity heavily dependent on the domestic market. This means that the role of external factors in the way monetary policy is managed is too high. In 2018, the degree to which the US economy was open[1] to outside factors was slightly under 14%, which is barely above the average since 2000 i.e. 13.7% vs. 13.4% average since 2000. The economy is no more dependent on the outside world than it was 10 or 15 years ago. So why change the factors that determine monetary policy by overlooking domestic aspects and only taking on board external dynamics?

Further questions on factors driving monetary policy

Questions to Jay Powell during press conferences should seek to address this question. Does this change reflect pressure from investors to get their hands on ever higher financial valuations? Is it the result of pressure from the White House as it wants the Fed to push interest rates ever lower? Is it because Powell has not set a clear doctrine on what monetary policy should be in this topsy-turvy world? These three factors can all be taken on board, but this rushed move makes for an economic policy error.

We can find another explanation for the Fed’s strategy

World growth is weaker than everyone would like. The world looks more fragmented than before and no longer has the coordination and cooperation momentum we saw just a few years back during the period of globalization. In other words, the dynamics of our world are increasingly diverging and this leads to uncertainty and dents growth.

Meanwhile, there no longer seems to be a way to conduct coordinated fiscal policy worldwide, and stimulus initiatives undertaken in 2009 seem to belong to a very distant past. The US, China and Europe have very differing views on this issue, so we should not expect a worldwide economic stimulus program, despite the fact that it would probably provide strong and sustainable support for the economy.

Central banks are all applying very accommodative policy to avoid putting any limitations on the world economy

In light of this situation, central banks worldwide are all applying highly accommodative policies to make sure they do not put any limitations on the economy. The aim is not to spur economic growth at any cost: growth projections from the ECB and the Fed most definitely do not point to this. Rather the goal is to limit the risks on world growth, and the ECB, the Fed, the Bank of Brazil and several other emerging country central banks have taken up this strategy, which can help explain why the aspects dictating US monetary policy focus on external factors.

Waiting for impetus from fiscal or technological factors

The only problem here is that this joint effort is admittedly necessary, but collective impetus looks a bit like a last-chance strategy while waiting for fiscal or technological stimulus to change the situation on a long-term basis. So central banks’ interest rates are set to stay low for a very long time to come: in this respect, the ECB indicated that its leading rate would stay where it is for such times as inflation does not move towards 2% on a structural basis. This could take a very long time – much longer than anyone expects. The Fed still has some leeway as compared to the euro area, but this could narrow very quickly.
The central banks are giving governments time to come up with some answers, but they will not necessarily hold on for as long as many would like.


* This document was posted on LeGrandContinent website. Le Grand Continent is a French think-tank on the geopolitical backdrop See the original post here in French
[1] The degree to which an economy is open to outside factors is the ratio between half of the total of imports and exports to GDP

The Federal Reserve reduces its rate as expected

The Federal Reserve reduced its interest rate by 25 basis points. It is now moving in the 1.75 – 2.00% corridor. The median rate for 2019 remains at the current level, therefore no further rate cut is expected in December. The monetary policy stance would be stable for 2020 at the end of 2019 level The reference rate would go up (25 bp per year) in the 2.00-2.25% corridor in 2021 and 2.25-2.50% in 2022. The long-term trend in the fed funds rate would then be 2.5% as in June.

The Fed and it’s chairman,Jerome Powell in his press conference, recognize that the economy is going pretty well. The central bank has marginally revised upward its growth forecast for 2019 to 2.2% against 2.1%.

The logic of the US central bank is as follows: the economy is doing well but its international environment is degraded. The decline in productive investment has thus to be perceived as evidence of the negative consequences of this uncertainty on the cycle. It is to strengthen the internal dynamics against external hazards that the Fed is loosening its monetary policy. This approach is new since generally the central bank becomes more accommodative when the economic situation is frankly weaker than currently observed.
This framework also means that in the event of a higher overall uncertainty, the Fed may not respect the rate profile derived from expectations. That’s what Powell said. Trade uncertainty and weaker global growth may create the need for lower rates to support domestic demand.

The main concern with such an approach is that the indicators of US economic policy are already very accommodative while the economy is at the peak of the cycle. The public deficit is $ 1,000 billion over one year in August and the real fed funds rate is now almost 0%. What mode of regulation will it be necessary to put in place during the economic downturn that will not fail to happen? I anticipate a sharp slowdown in the second half of 2020. Will the public deficit rise to 6 or 7% of GDP and the Fed rate land in negative territory?

Finally, we note that the measure taken does not reflect an unanimous vote . James Bullard wanted to go further while Esther George and Eric Rosengren were in favor of the status quo. As with the ECB, the measures taken no longer succeed in silencing differences. Behaviors change because the diagnosis is not so uniform.