To the Point
Discussion on the economy, by the Chief Economist October 27, 2009
It is all about timing
To the Point is a new monthly publication from Swedbank’s Economic Research
Department. It provides discussions on the global economy based on analysis,
economic research and forecasts. The financial crisis – with severe consequences for
business and public institutions – has reminded us to take a holistic perspective, by
combining the macro with micro, as well as economics with psychology and an
understanding of the political reality.
This first publication focuses on the uncertainty regarding the business cycle and the
Cecilia Hermansson
Chief Economist outlook for price developments. At the centre of the analysis, are the issues of exit
Swedbank strategies, regulation and macro economic imbalances. Ultimately, timing will be the
Economic Research Department key. Will global leaders make necessary regulatory changes in time? Will these
+46-8-5859 1588 leaders find the exact time to pull back stimulus measures? The world has not become
cecilia.hermansson@swedbank.se less fragile: to find the perfect time for action may make the difference between
success and a new collapse.
In this issue, you will find the following topics:
1. Growth will bounce back in the short run, but be sluggish in the medium run.
2. Deflation risks today may become inflation risks tomorrow.
3. Exit strategies from stimulus measures are the global
leadership’s main challenges.
4. Will regulation reform come in time to avoid new bubbles?
5. Global macroeconomic imbalances will not be fixed overnight.
To summarize, the growth outlook looks quite good in the short run, but clouds are
building up for the medium and long term. The deflationary risks, while abating, are
still present and inflation risks for the medium term are increasing. It is unlikely that
governments and central banks will withdraw stimulus at exactly the right time, and it
will be easier to err on the side of too late rather than too soon. Regulatory change is
needed, but the right time may not be now: change must come when the recovery is in
place otherwise financial instability will continue. China and the US are still a couple,
but may need “marriage counselling”. Europe and Japan will bear the main burden of
currency adjustment when the dollar weakens further, unless China joins the group,
by liberalizing the yuan and focusing on stronger private consumption. But all this
will take time.
Improved growth prospects – in the short run
Economic growth has come back earlier than many, including myself, expected. The
main difficulty for analysis was to project which force – deleveraging or stimulus –
would be the strongest. Now we know: stimulus has won – at least in the short run.
Germany, France, Japan and Sweden, all showed GDP-growth in the second quarter –
and the US is set to follow during the third quarter as government spending and a
slower pace of destocking increase activity. In the short run, growth prospects are
decent because of
• gigantic stimulus measures related both to fiscal and monetary policy;
• an inventory cycle that is adding, rather than subtracting from growth;
• increased risk appetite and higher confidence;
• moderately recovering credit markets;
• a resilient Asia that supports world growth; and
No. 1/2009 • continuing but slow deleveraging.
To the Point (continued)
October 27, 2009
In the medium to long term, i.e., after 2010-2011, the task of maintaining
Many markets are being manipulated
growth will become more challenging as support measures will have to be
withdrawn and economic policy will be tightened. At the moment, because
many markets are being manipulated by these measures (bonds, shares,
commodities, houses, cars, etc), it is difficult to estimate “real” demand and
In the US, employment is falling and productivity is “real” price developments.
increasing …
In the US, one can be concerned about the high unemployment rate, which
has reached almost 10 %. About 8 million have lost their jobs, and another 9
million are working part time involuntarily. Almost half of those in the labour
… but Germany has taken the opposite route force have either lost their jobs, had to accept reduced working time, or seen
their salaries decline during the last year. On the other hand, productivity has
increased rapidly and the US is adjusting to new developments; this could be
positive when the recession ends.
Watch out for lower potential growth! Germany, is the true opposite of the US, as employment has been fairly stable
and productivity has declined. If demand comes back soon, labour hoarding
may have been the right thing to do. More likely, though, German
unemployment will continue to rise, thereby only postponing the necessary
Chart 1: Industrial production and leading
adjustment.
indicators in the OECD
In the medium to long term, the clouds get darker. The expected loss in global
10 output will be hard to replace. More serious, though, would be lower potential
growth going forward. Investments will be weak as capacity utilization is low,
5 and that means fewer possibilities to increase productivity from the capital
stock. However, reports from the IT sector show that the willingness to add
new technology remains. Lower potential growth could also come from the
0
Percentage change
labour markets’ weakening, the financial sector’s shifting into reverse, and
globalization’s slowing. Policy could make a difference – watch out for
-5 protectionism and long-term unemployment!
Industrial production in the OECD
-10
The OECD has lost 10 years of industrial production due to the financial
crisis and the recession. Leading indicators and Purchasing Managers’
OECD Leading Indexes show improvements – the recovery is starting. However, it will take a
-15 indicators long time – several years – to get back to the pre-downturn 2008 level.
-20
85 87 89 91 93 95 97 99 01 03 05 07
Why there are risks for deflation – but also for
Source: Reuters EcoWin
inflation
The deflationary risks have abated as risk appetite and confidence are
increasing, fuelling prospects of higher demand. However, it is still too early
to rule out a deflationary climate. As wages and prices are falling in the US,
Deflationary risks have abated, but can not be
as well as in many other parts of the world, the current situation could still be
completely ruled out
characterized as deflationary. In many parts of Europe, the CPI is perhaps
more disinflationary, as base effects from high interest rates and commodity
prices during 2008 explain why prices are falling today. Wage negotiations
are still indicating positive wage growth in Germany, Sweden and other
European countries, although at much lower rates than before the crisis.
Below, are four scenarios based on price developments and economic growth.
It makes sense creating four growth and price “No growth” is basically negative or very weak growth, below potential,
scenarios while “growth” is something close to or above potential. “Inflation” would be
price increases (core) of around 4-5% or more, while “deflation” could be
either disinflation, i.e., lower inflation due to technological progress, or
deflation (the bad or ugly version where demand and prices fall in a vicious
spiral).
2
To the Point (continued)
October 27, 2009
So where do we go from here? The most positive outlook would be for
disinflation and growth, i.e., the arrow moving north. We have seen similar
developments globally during many years as the IT sector increases
productivity and globalisation leads to lower prices. This scenario would
Chart 2: Growth and price scenarios
work only if policy makers succeed in pulling back stimulus measures at the
perfect time. If not, we could expect to see the arrow moving north-east into
Deflation Inflation growth and inflation – or even worse – east into no growth and inflation, i.e.,
stagflation.
Growth What is the most likely scenario? I see a high probability for a period with no
or sluggish growth and deflation (where X is in the matrix), followed by
higher inflation and growth (north-east). The reason? Stimulus is huge. It will
be difficult to succeed with the perfect timing, and most policy makers would
rather err on the side of pulling back too late than too soon. The signals from
Germany’s new government are clear: we would rather boost growth than fix
X No Growth budget deficits. In other words, we’ll deal with one “hell” at a time.
When and how to exit from stimulus measures
During next year (around summer), major central banks will start hiking
interest rates. Already now, liquidity is being pulled back automatically as
financial institutions no longer need support. For the US Federal Reserve and
The withdrawal of stimulus come in three steps: the Bank of England, the shrinking of central bank balance sheets could be a
bit more complicated, especially for the US, which will attempt to get rid of
1) Absorb liquidity and stop unconventional mortgage- backed securities without hurting the recovery on the housing
monetary policy market. With credit easing and quantitative easing employed as
unconventional policies, exit strategies must include both interest rate hikes
2) Increase interest rates and use conventional
monetary policy and the selling of assets, such as government bonds. Still, it will take several
years before central bank balance sheets are back to the levels seen before the
3) Increase taxes and cut spending to start crisis.
consolidating budgets and reduce public
debt It will be more difficult to stop fiscal stimulus measures, and new packages to
limit long-term unemployment can not be ruled out, even if the political
reality may hinder such a development – in the US for example. In 2011,
expansionary fiscal policy will be followed by a neutral and then
contractionary policy. Still, public debt in many large economies in the
Chart 3: Central banks’ policy rates
OECD will reach all-time highs and stay there for a long time. Real interest
7 rates could increase when problems of crowding out start to be visible.
6 UK Looking at the output gaps, which may be as wide as 8-10%, expansionary
policy will make sense for a long time. However, it is difficult to measure
5 output gaps, and we can not rule out inflation also in a situation where there is
Euroland ample capacity. Confidence in central banks’ independence and their
Percent
4
commitment to maintaining price stability is important. This is also why it is
3 important to make clear on the exit strategies, without hurting the recovery
2 process helped by the stimulus measures.
US
1
Sweden Will governments and central bankers succeed in exiting in the right way and
Japan
at the right time? Central banks can raise interest rates on banks’ reserves at
0 the central banks. Government bonds and other assets can be sold. Repo rates
00 01 02 03 04 05 06 07 08 09
can be increased. And it will be important to coordinate monetary and fiscal
Source: Reuters EcoWin
policy. To find the right moment for action, however, is more complicated.
The recovery must be in place, but financial markets and investors should not
have started to be concerned. It is all about timing!
3
To the Point (continued)
October 27, 2009
The right time for regulatory changes
Financial markets have a tendency to create bubbles We can agree that financial markets have a tendency to develop bubbles. The
implication for regulators is clear: markets can not be expected to correct
excesses. Central banks and governments are good at cleaning up after the
bubbles have burst, but they do not have the knowledge on how to avoid
bubbles from being blown up. The current situation is a case in point: low
interest rates for a long time may create new asset price bubbles. It could be
worth creating new bubbles to get the economy going, but doing so could lead
to new problems – perhaps after some time. Then a new cleaning action is
needed.
Already now, Swedish credits to households are growing at full speed, and
their debt ratio (total household debt in relation to disposable income) will
increase from 160% at present to 200% in 2011 if the credit growth continues
at this rate till then. Central banks must keep an eye on credit growth, and
could regulate the way households take variable or fixed interest loans, the
loan-to-value ratio, how much amortization should be required, etc.
Governments could focus on reducing interest rate deductibility, or take other
measures that could cool the housing market. However, no such measures are
Moral hazard is one of the serious side-effects of this likely – neither political nor economic reality would allow it.
financial crisis and the problem of too big to fail has
increased On a global scale, banks and other institutions are again increasing risk
appetite, and there is a concern about new systemic risks. Not the least,
because “too big to fail” or “too interconnected to fail” has become a bigger
problem since the crisis. Moral hazard is one of the serious side-effects of this
crisis. As long as governments and central banks focus on cleaning up after
Timing may not be right to start the anti-bubble the bubbles have burst, financial institutions can always count on being saved
strategy – but regulatory changes must come when the from collapse.
recovery is in place
Will regulations change in time, or will new bubbles be created? Most likely
it will take time for G20-countries to agree on methods. In addition, making it
more difficult for banks to lend right now could be counterproductive and
hurt the recovery. When credit markets have improved in a more robust way
and when the economic recovery is in place, the time for regulatory changes
Chart 4: The Euro, Yuan and Yen against the US will have come. The main goal should be to increase the prospects for
dollar (Index 100 = 2007)
financial stability, while maintaining the focus on price stability. This will
170 require a shift in thinking in central banks – away from a partial analysis of
160 consumer price inflation targeting and towards a reliance on a more holistic
150
Euro against the US dollar framework. It has to come – it’s all about timing!
140
Does the US and China need marriage
130
counseling?
120
Yuan against the US dollar
One of the lessons learnt during the crisis is the need to fix macroeconomic
110
imbalances between the US (and other current account (C/A) deficit
100
countries) and China (and other C/A surplus countries). The US C/A deficit
90 has been sliced in half to some 3% of GDP, but China continues to increase
80
Yen against the US dollar its surplus. In addition, if economic policy is not changed – which it has not,
70
as the US gives cash for clunkers to boost car consumption and China
98 99 00 01 02 03 04 05 06 07 08 09 supports export developments and keeps the exchange rate pegged to the US
Source: Reuters EcoWin
dollar – a large C/A deficit in the US will return again after some years.
4
To the Point (continued)
October 27, 2009
Chart 5: GDP-growth in China, India, Sweden, Or perhaps the China-US “marriage” is not working after all? Both parties
Euroland, Germany, Japan and the US (%) may eventually decide they would like a divorce, but not yet. The US needs
China as China continues to buy US treasury bonds, and China can thereby
15.0 exacerbate both US fiscal problems and risk a much weaker dollar. China
China
12.5 builds capacity as perhaps 75% of growth now comes from investment
10.0 financed to a large extent by the public administration. US is still an
7.5
India important export market for China.
5.0 Sweden
There is an understanding that both countries need a more balanced growth.
Percent
2.5 This does not mean it will happen. To increase consumption in China, social
0.0 security must be developed including through pensions and reasonable tuition
-2.5 Germany US and health fees. To open up capital markets and liberalize the foreign
Euroland
exchange system will be a challenge, as the risks for financial instability
-5.0
increase and lower export prospects create potential for both political and
-7.5
Japan
social instability. The most likely scenario is a slow pace of appreciation, a
-10.0 process that will start again when world demand is growing more solidly.
00 01 02 03 04 05 06 07 08
Meanwhile, the expectations are asymmetrically geared towards appreciation
Source: Reuters EcoWin
– a situation that can build asset price bubbles à la Japan or worse.
For the US, the balancing has started but the question is if it is sustainable.
Households have increased savings, to compensate for great wealth losses.
Still, 70% of GDP is made up of private consumption. To find alternative
growth engines is not easy. For a while, inventories and net exports can
provide some relief. However, to continue growing with the help of the export
sector, the dollar should probably have to weaken further.
The third party – watching the married couple muddle through – is the euro
area. Much of the adjustment falls on the euro, and a much stronger currency
could start to weaken 2010 growth prospects. It is necessary for Japan,
Germany, Sweden, and other “mercantilist” countries to accept a stronger
currency in order to reduce imbalances, but it would make sense if China
could join this group. It will happen – it is only a question of timing – but I
wouldn’t be surprised if it was later rather than sooner.
Cecilia Hermansson
Economic Research Department To the Point is published as a service to our customers. We believe that we have used reliable
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Cecilia Hermansson
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