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Economic Update: Expansion's Midcycle Yields Unchanged Policy

April 2014

Richard B. Hoey

Chief Economist, BNY Mellon and Dreyfus

Chief Economist Richard Hoey presents his April 2014 Economic Update

We believe that both the overall global economy and the U.S. economy are in the midcycle phase of a prolonged economic expansion with growth likely to accelerate in 2014, 2015 and 2016. Within that multiyear period of faster economic growth there should be temporary subcycles of faster and slower growth. We believe the U.S. growth stall in the early part of the first quarter of 2014 reflected temporary or one-time factors, including the unfavorable weather, expiration of extended unemployment benefits and the deceleration of unsustainable inventory accumulation. This short subcycle phase of weakness is likely to be followed by an accelerated U.S. economic growth rate due to a fading of both past financial stresses and the fiscal drags in the Federal, state and local government sectors.

We also expect a regional variation in the pattern of global economic expansion. The global acceleration should be led by advanced countries, including the UK, the U.S and Europe (growing slowly but recovering from its double-dip recession). Japan faces peculiar variability as the recent hike in the value-added tax should generate several months of sharp economic declines, especially in the small business sector of the economy, followed by moderate expansion. China is also out of synchronization with the overall global economy. It is experiencing a sustained downward shift in its long-term trend growth rate.

The midcycle phase of economic expansion tends to occur after much of the financial hangover from the prior crisis has faded but before central banks are motivated to restrain economic expansion in order to suppress excessive inflation. After nearly five years of economic expansion, central banks are usually tightening monetary policy to restrain above-target inflation. Many central banks in advanced countries are indeed worried about inflation today, but they are worried that inflation is too low rather than that inflation is too high. This is having a profound impact on monetary policy. We divide monetary policy into five phases: (1) aggressively stimulative, (2) stimulative, (3) neutral, (4) restrictive and (5) aggressively restrictive. After five years of economic expansion, monetary policy is often restrictive or aggressively restrictive, designed to slow or stop economic growth. Today, in contrast, monetary policy in many advanced countries is aggressively stimulative, only partially offset by growth-hostile regulation. In the UK and the U.S., central banks are finally beginning or contemplating "baby steps" of reduced accommodation, while in both Japan and the Eurozone, further stimulative actions are likely. With core inflation below target in many major countries, the overall stance of monetary policy in advanced countries should remain supportive of economic expansion.

Within the advanced countries, the financial hangover of the last crisis is fading. Financing costs for peripheral European sovereigns and for high-risk corporate borrowers in the U.S., UK and Europe have dropped sharply. In addition, fiscal drags are fading in key countries. As a result, a smaller portion of monetary ease is now needed to offset the growth-suppressing impact of (1) the hangover from the financial crisis and (2) successive rounds of fiscal austerity. Both drags are now fading.

A key current debate is the outlook for the Chinese economy. The Chinese economy has delivered rapid growth over the last several decades as the productivity of the Chinese workforce has risen powerfully as modern technology and intellectual capital have been diffused throughout the Chinese economy. China is now at a downward inflection point for its long-term trend growth rate for multiple reasons, including a demographic shift. The number of entry-level workers is now declining and its working-age population is in the process of shifting from annual increases to annual decreases. While this is slowing China's potential GDP growth, it also means that Chinese economic growth can slow to some degree without a substantial rise in unemployment. Several years ago, China engineered a credit boom in response to the global financial crisis. Credit growth has since decelerated and China must now deal with the resulting financial hangover.

A key issue in China is potential instability in the "implied guarantee." The "implied guarantee" on the deposits in the large banks of China is very likely to be honored, since these banks are closely tied to the central government. However, the Chinese authorities appear to be trying to weaken expectations of an "implied guarantee" on investments in the shadow financial system. The authorities have been tentative so far, since public expectations could prove volatile. With property sales slowing and caution about the shadow financial system spreading, credit-financed growth is likely to slow further in China.

There are some mitigating conditions. China is an international creditor, not an international debtor. While the high savings rate is one of its imbalances and helps create asset mispricing, that high savings rate also implies a substantial flow of investable funds, which is largely retained inside China due to capital controls.

The increased size of China's economy relative to the global economy over the last several decades has two implications: (1) a true "hard landing" in China would have a very negative impact on the global economy and (2) even a somewhat decelerated pace of sustained growth in China would make a substantial positive contribution to global economic growth. Over the last several decades, there has been a major mix shift in the global economy, with a lower weight for slower-growing economies and a higher weight for faster-growing economies. This helps to offset some of the impact on global growth of the downward shift in trend economic growth in many countries. Given the sluggish outlook for Chinese real estate, we expect slow growth in China at about a 7% pace near term, and a 6% pace long term, rather than a "hard landing."

Many emerging countries are sensitive to demand from both the advanced economies and China. We expect a moderate cyclical acceleration of growth rates in the advanced economies even as the trend growth in China is shifting down. Many emerging countries will be expanding at only a moderate pace relative to their past growth rates. Emerging countries are not a homogeneous economic bloc, but have disparate economic characteristics, including (1) export dependence on Chinese domestic demand, (2) export dependence on advanced economies, (3) current account balances, (4) domestic debt burdens, (5) real interest rates and (6) inflation rates relative to central bank targets. However, we believe that medium-term economic policy credibility is key to differing trends among emerging countries, as it should prove critical to the cost of credit and business confidence in individual countries.

While the euro is labeled the "single currency," sometimes it is helpful to think of it as 18 different currencies locked together at a fixed exchange rate. The economic reality of the shadow "Euro-Deutschemark" is quite different from that of the shadow "Euro-Drachma" or the shadow "Euro-Peseta." The 18 currencies have the same nominal central bank policy interest rate and the same nominal exchange rate. However, because they have different inflation rates and different competitiveness, they have different real interest rates (interest rates minus inflation) and different real exchange rates. The strength of their banking systems are also different, resulting in differences in the transmission of monetary policy. Financial conditions are easier in the core countries (low real interest rates, moderate real exchange rates, strong banking sectors) than in the peripheral countries (high real interest rates, high real exchange rates, vulnerable banking sectors). With substantial excess capacity and private sector credit availability still tight in the periphery, some countries are vulnerable to disinflationary or deflationary pressures. These tend to raise real interest rates, raise the real value of debt and contribute to downward pressure on the overall inflation rate in the Eurozone. The longer the overall inflation rate in the Eurozone stays low, the higher the risk that inflation expectations could drop substantially.

The euro has been relatively strong due in part to a high current account surplus reflecting the combination of a high German surplus and weak imports into the sluggish peripheral economies. The ECB has become concerned that if the strong euro and low Eurozone inflation persist, a drop in inflation expectations might raise expected real yields and become a drag on the European recovery. As a result, there are increasing odds that the ECB will adopt a slightly negative deposit rate while retaining the threat of private sector quantitative easing and/or public sector quantitative easing. Our most likely case is that the ECB will prove correct that European inflation is making a gradual bottom. If so, the ECB may not need to adopt quantitative easing. The economists' tool-kit is poorly designed to forecast geopolitical events, but concerns about the risk to the Russian economy from the situation in the Ukraine could lower the resistance of Germany and its allies to supporting stimulative moves by the ECB.

We believe that the core of the Federal Open Market Committee is committed to a dovish monetary policy stance. For now, both parts of the Fed's dual domestic mandate (price stability and maximum employment) support an easy monetary policy. While some concerns have been raised about the potential risks of easy Fed policy to financial stability (notably in the speeches of departing Federal Reserve Governor Jeremy Stein), Fed Chair Yellen has continued the Greenspan/Bernanke tradition of downplaying the responsibility of Federal Reserve policy for the creation of financial bubbles in the U.S. economy. While tightened financial regulation has generated reduced leverage in the regulated banking system, pockets of excessive risk-taking have begun to emerge outside the regulated banking sector.

While excessive risk-taking does not yet threaten the overall U.S. economy, we believe that the downward suppression of U.S. bond yields by the Federal Reserve generates three threats: (1) pockets of excessive risk-taking in portions of the U.S. and global economy, (2) the potential for an eventual disorderly exit from the easy monetary policy if normalization of interest rates is badly timed and (3) an erosion of Federal Reserve policy independence, as it has taken on some responsibility for the yield on Treasury bonds. Federal Reserve independence was achieved in 1951 when it stopped pegging the Treasury bond market during the Korean War. For further detail, see "The Treasury-Fed Accord: A New Narrative Account," published by the Federal Reserve Bank of Richmond.

Fortunately, the U.S. economy is not currently very inflation-prone with respect to consumer prices. As a result, we believe that a gradual normalization of interest rates over the next several years is possible. We expect that the Fed will eventually find itself "behind-the-curve" by retaining its easy monetary policy for too long, and, therefore, a more intense interest rate spike is likely to occur in 2017 or 2018. In the meantime, we expect a monetary policy supportive of a modest acceleration of U.S. economic growth.

We do not expect significant financial tightening in the near term. The budget deficit has dropped substantially due to (1) cyclical recovery of tax revenues, (2) continuing Federal spending restraint due to the sequester legislation passed in 2011, and (3) tax increases legislated to avert the fiscal cliff in the winter of 2012-2013. As a result, the Treasury Department's need for financing has dropped at a time when the Federal Reserve has been withdrawing long-duration Treasury bonds from the markets. Netting Federal Reserve bond purchases from Treasury bond issuance, the U.S. has been "short-funding" its budget deficit, which itself has dropped. The high-grade corporate sector has succeeded in refinancing much of its debt at low interest rates. Due to a combination of high profits and corporate "long-funding" at low interest rates, high-grade U.S. companies have strengthened their balance sheets even as the new issuance of high-risk bonds by highly leveraged companies has surged.

We believe that wage inflation and core inflation in the U.S. have just bottomed. We believe that they have begun a gradual, multiyear uptrend which will not end until 2017 or 2018 in an environment of restrictive monetary policy. We believe that the effective supply of labor may be lower than it appears to be for several reasons: (1) faster decline in short-term unemployment than in total unemployment, (2) permanent withdrawal from the workforce of older workers during several years of a weak labor market, (3) reduced medical insurance "lock-in" due to the Affordable Care Act and (4) a rise in the effective median marginal tax rate on wage and salary income. Because the upward drift in wage inflation that we expect begins at a depressed pace and should be gradual due to the usual lags, Federal Reserve policy is likely to accommodate rather than resist the uptrend in wage inflation.

Given that the labor share of national income is the lowest in many decades, we believe that increased wage inflation is likely to be welcomed both by the Obama administration and the general public. We expect a gradual uptrend in wage inflation to be first welcomed and then later tolerated by the Federal Reserve. As Chair Janet Yellen has stated, "...something between perhaps 3 and 4 percent wage inflation would be normal...wage inflation has been running at 2 percent." Note that a well-tolerated gradual upward drift in wage inflation would be consistent both with our expectation of about 3% real GDP growth for the three years 2014, 2015 and 2016 and with the likelihood of an upward spike in interest rates in 2017 or 2018.

The Federal Reserve has indicated that it currently intends a real Federal funds rate (Federal funds rate minus inflation) well below historical norms when the U.S. economy reaches full employment. We believe that it will follow through on that plan, but the consequence is likely to be a surge in inflation above its target in 2017 or 2018, triggering a shift to restrictive policy after the Presidential election of 2016. In the meantime, central bank policy supports an acceleration of economic growth, likely resulting in three years of economic growth averaging about 3%.

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