Chief Economist Richard Hoey presents his October 2013 Economic Update
All economic forecasts today are subject to uncertainties about the U.S. government shutdown, debt ceiling worries and concerns about potential U.S. default. Our belief is that default will not occur, that the debt ceiling limits should be raised by October 17 and that the government shutdown should last only for the first two to three weeks of October. If so, damage to the U.S. economy is likely to be limited and largely temporary. However, a longer period of uncertainty could have more negative effects on the economy and the markets. The debt ceiling concerns this October have arisen just prior to the key decision-making period for consumers on holiday spending and for corporations on finalizing next year's investment plans. We expect at least a short-term resolution before that key period. However, a longer period of debt ceiling uncertainties could prove problematic.
One mitigating factor is that the central banks have flooded the economy and the financial markets with liquidity over the last several years, so the number of entities subject to short-term funding risk is much more limited than it was during the financial crisis. During the financial crisis, the problem was an ability to pay. The current issue is a political willingness to pay, which can potentially be cured much more quickly.
After two years of sluggish global economic growth within a sustained expansion, we expect an acceleration in global growth in 2014, led by better growth in key developed countries. Growth in many developed economies should be supported by the impact of easy monetary policy, lower fiscal drags and reduced pressures for private sector deleveraging.
We expect disparate trends in different emerging market countries. Long-term policy confidence is critical for the outlook for individual emerging countries. Where there is credibility to multiyear reform plans, the growth outlook should improve. Where policy is inflexible, growth should remain sluggish. Global inflationary pressures are subdued, so some of the inflationary pass-through from recent currency weakness in emerging countries should prove temporary.
The China boom has decelerated into a China expansion as structural adjustments are occurring. For demographic reasons, new entrants to the labor force have dropped. Despite an ample supply of white collar workers, the supply/demand balance for blue-collar workers has tightened. In response to this reality, the Chinese government has tolerated a wage inflation, making China less competitive for low wage industries. China now faces several financial issues, notably including poor capital discipline in capital spending decisions. In contrast to the pessimists, we believe that China should be able to avoid financial contagion and amortize the cost of past malinvestment over an extended period of time.
In the Eurozone, the ECB policy of "whatever it takes" has proved to be very successful in calming financial stresses. In prior years, shifts in the Target 2 balances at the ECB were a disguised mechanism for absorbing and transferring credit risk within the Eurozone. The reversal to a declining trend in Target 2 balances reinforces many other indicators of calming financial stresses in Europe. The 2012 understanding between Mario Draghi and Angela Merkel for conditional liquidity support for peripheral countries, subject to a German veto on the conditions for support, has been a critical factor in financial stabilization. Our expectation has been that the European double-dip recession would end by mid-2013 and be followed by a weak economic expansion. We believe that recent economic data supports that outlook.
We are optimistic that the euro will remain intact and that Europe is entering a period of sustained economic expansion. However, we are pessimistic about the sustainable growth rate in Europe in the coming years. Demographics are unfavorable, labor market reforms in Southern Europe are incomplete and debt burdens remain high. Cyclically, however, the transition from a painful double-dip recession to sluggish economic expansion in Europe is a positive both for Europe and for the global economy.
The U.S. economic outlook can be divided into two parts. First, what is the cyclical outlook, assuming the outcome of the Washington political battle is not disastrous? Second, how will the Washington battle be resolved and what will be its economic consequences?
We believe that the U.S. has passed the midpoint of a prolonged seven-year economic expansion. This expansion should be prolonged because it has been slow, which has postponed the rise of inflationary pressures which are the usual cause of a shift to restrictive monetary policy at the Federal Reserve. Recessions tend to be triggered either by an oil price spike, or by a shift to aggressively restrictive monetary policy, or by both. Neither appears likely for the next several years.
Within this prolonged seven-year expansion, we expect an acceleration in U.S. real GDP growth from the average pace of about 2% in the last four years to about 3% in the next three years (2014, 2015 and 2016). We do not expect that the reason for such an acceleration will be the emergence of new sources of strength. Rather, the main cause of faster U.S. economic growth is likely to be a fading of past drags on the economy: the Federal fiscal drag is falling, state and local spending is improving somewhat, household deleveraging is largely complete for this cycle, and Europe is shifting from a double-dip recession to a modest expansion.
What about the Washington risks? We believe that reckless rhetoric from both sides of the political battle in Washington does not imply that reckless decisions will be reached in the end. Washington's political culture has deteriorated badly as the moderate middle of the electorate is underrepresented in Washington. However, we are convinced that pragmatic decisions will be made in the end.
The concerns over the debt ceiling struggle are occurring after a prolonged period when the financial system has been flooded with liquidity, corporate profits have risen sharply and house prices have begun to recover. The number of entities subject to severe short-term funding stress is much lower than during the financial crisis. As a result, we believe that both the economy and the financial sector are likely to prove relatively robust to the worries about the political battles in Washington as long as actual default is avoided, which is our strong expectation.
There is an ongoing multiyear political war in Washington, D.C. about the size of the Federal government's share of the U.S. economy and the division of decision-making power between the Federal government, the states and the private sector. Despite a succession of noisy political battles, we expect only minor shifts from the priorities embedded in current law. We believe that, on both sides of the political spectrum, the negative power to block any major changes in current laws is greater than the positive power to make major changes. We expect trench warfare in Washington for the next several years, but no policy disaster and only minor policy changes.
We continue to expect a three-phase upward adjustment of bond yields over a half-decade period, as outlined in our report entitled "Interest Rate Normalization" dated September 12, 2013. The first phase is an adjustment to free-market levels from artificially low bond yields, which reflect an artificial scarcity of bonds due to large scale bond purchases under QE3. This adjustment is underway, but in a choppy pattern, given the volatility in the expectations about Washington risks and the timing of the first taper of QE3. Since the Fed decision to begin to taper QE3 is data-dependent, we expect that the first taper is likely to be postponed until early 2014, when we expect the economic data to normalize after all the data disruption from the government shutdown and the debt ceiling concerns. Given low inflation and the views of the recently nominated Janet Yellen, we expect the zero rate policy to persist until at least mid-2015 and potentially beyond.
The second phase described in our "Interest Rate Normalization" report is a gradual upward drift in free-market interest rates over the next several years as the growth rate of both nominal GDP and real GDP accelerates and the unemployment rate falls. After the next several years, the Fed should eventually end up "behind the curve" in its monetary policy. The consensus at the Federal Reserve is that full employment will be reached by the end of 2016, but that the Federal funds rate should then be only about 2%, one half of the Fed's estimate of the long-run normal Federal funds rate of 4%. Only time will tell whether that is correct, but the clear consensus at the Federal Reserve is tilted towards a concern about excess unemployment rather than towards a concern about a potential future acceleration of inflation, a tendency likely to be reinforced under the Fed's new leadership. We expect a slow buildup of the pressure for a major upward spike in interest rates in 2017 or 2018, following the Presidential election of 2016.
The economic impact of an interest rate rise is very sensitive to the cyclical stage of monetary policy. In our view, there are five stages of monetary policy: (1) aggressively stimulative (2) stimulative, (3) neutral, (4) restrictive and (5) aggressively restrictive. The Federal Reserve plans an eventual move from aggressively stimulative to merely stimulative. Not all interest rate increases are the same. We expect that interest rates would gradually drift higher over the next several years, not because of excessive inflation, but rather because of favorable news on the sustainability and strength of the economic expansion. Overall, we expect a prolonged period of easy monetary policy and a prolonged economic expansion.
The statements and opinions expressed in Mr. Hoey's commentary are those of Mr. Hoey as of the date of publication, and do not necessarily represent the views of BNY Mellon or any of its affiliates.
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