1. Trend Output Growth: Lower
The pace of the expansion during much of the last decade proved unsustainable, having been predicated on growing imbalances which, ultimately, had to be corrected - a correction that is ongoing. Growth over the next decade will likely suffer from the need to retool entire economies - for example away from the construction sector towards export sectors - and structural change takes time. At the same time, stalling or receding globalisation will likely impact economic efficiency and hence productivity. And high levels of public and private debt in many DM economies are likely to weigh on growth. In short, while towards the end of the decade output growth may well be back at its long-term historical norm, we believe that it will remain subdued in the interim.
2. Output Volatility: The End of the Great Moderation
The 25 years prior to the Great Recession were characterised by a marked reduction in the volatility of output and in the level and volatility of inflation - the Great Moderation. With the exception of periodic financial crises - most of which were confined to EM economies - the absence of large shocks and better economic policies led to remarkably stable output growth in DM and many EM countries. The Great Recession and the accompanying increase in public debt will mean, effectively, the loss of fiscal policy as a stabilisation tool (see also below). Given that many economies are now at or near the fiscal limit, even small shocks can push sovereigns into debt crisis territory. Hence, debt-financed fiscal policy becomes unavailable as a stabilisation tool not only for big shocks such as financial crises, but also for countercyclical purposes. Worse, fiscal policy will likely become procyclical for economies at the fiscal limit. And while we are less certain about commodity price trends, commodity price volatility may further add to the mix. In short: expect output to be more volatile over the next decade.
3. Monetary Policy: Inflation Targeting 2.0
The loss of fiscal policy as a stabilisation tool means that the burden of stabilisation falls on monetary policy. All else equal, this should lead to more volatile interest rate-setting: Central bank policy rates will have to be hiked higher, faster, or cut lower, sooner. But all else will not be equal. The increased burden for central banks, and the necessity to prevent instability arising from asset price misalignments, will likely mean important institutional changes in monetary policy. How will monetary policy be conducted? In decreasing order of likelihood:
•· Maintain inflation targeting but adding a macroprudential tool: Inflation Targeting 2.0 (see "Inflation Targeting 2.0", The Global Monetary Analyst, September 29, 2010). This also means a convergence of price and financial stability policy under the central bank roof.
•· Price level targeting (the Bank of Canada is looking into it already) has the advantage of more automatic stabilisation of inflation expectations (see "From Inflation Targeting to Price Level Targeting?" The Global Monetary Analyst, July 15, 2009).
•· Increase the inflation target (to 4%, say), taking policy rates away from the zero lower bound to make more room for cuts when necessary.
4. Inflation: Regime Change
In the early 1980s, central banks browbeat inflation into submission. Institutional changes in monetary policy, globalisation, product and labour market deregulation, a productivity growth spurt, and a decent dose of good luck kept inflation very low subsequently. Globalisation will likely provide little further competitive impetus. Ditto for deregulation. Productivity growth will likely be lower. And good luck is not something one can count on forever. In short, the one-off factors that have kept inflation well-behaved can no longer be counted upon. Perhaps more importantly, the very high levels of public (and private) debt in many DM economies have dramatically altered the landscape for monetary policy (see "Debtflation Temptation", The Global Monetary Analyst, March 31, 2010). With low growth, high unemployment and high debt, societal preferences will likely move away from price stability - and central banks don't operate in a vacuum.
5. Public Debt: Going Clubbing
The expansion of global capital markets over the past 30 years made available large amounts of excess savings, mainly from Asia (Japan initially, then Emerging Asia) to DM governments. This allowed them to run up debt cheaply over the past two to three decades. Because of low real interest rates it was feasible for politicians to borrow rather than raise taxes or cut spending. With high initial levels of public debt, the crisis and the Great Recession then brought many governments close to their fiscal limit. We think that the split that has emerged between ‘good' and ‘bad' sovereign credits will persist over the next decade. Indeed, the ‘bad' credits club is likely to grow because of the asymmetric dynamics of membership: while a transition from ‘bad' to ‘good' will take a long time, moving from ‘good' to ‘bad' will be much faster in a world of heightened risk-aversion and deficit intolerance. More broadly, many DM sovereigns have now found out the hard way what EM economies have known for some time now: the market does enforce fiscal sustainability - eventually. Note that the great public deleveraging will, in economies that are net debtors vis-à-vis the rest of the world, likely be accompanied by private sector deleveraging. This means the economy as a whole is deleveraging - i.e., current account deficits will likely become compressed or even reversed.
6. Real Interest Rates: Higher (Moderately)
Real interest rates were exceptionally high in the early 1980s and have declined steadily ever since, only to be reduced further by the Great Recession. Given how extraordinarily low real interest rates are right now, the question is not so much the direction of the move - up, in our view - but its size. Over long enough time horizons, real interest rates are driven by savings and investment flows. Hence, real yields will be pulled in different directions by the various structural forces that affect these flows. Factors that, in isolation, will drive the real yield lower over the next decade are:
•· Public deleveraging means government saving (dissaving) goes up (down).
•· Private saving is likely to increase in many DM as households rebuild their wealth, particularly with a view towards their (imminent) retirement; and as higher output volatility raises precautionary saving.
There are also forces that, in isolation, will drive yields higher:
•· Higher macro risk will mean higher risk premia and hence higher real yields.
•· A stronger real (i.e., inflation-adjusted) trade-weighted exchange rate for CA surplus economies will increase domestic consumption and reduce export surpluses. That is, saving in CA surplus economies will decline (since export surpluses are just a form of deferring consumption to the future, i.e., saving).
•· Structural change - towards export sectors in many net debtor economies, towards domestic sectors in many net creditor economies - will necessitate a change in the composition as well as the size of the global capital stock. This will likely be a major driver of investment demand.
The question of the net impact of higher saving in CA deficit and lower saving in CA surplus economies on the real interest rate is difficult to answer. We think that higher risk premia and strong capex demand will ultimately tip the balance in favour of higher real interest rates. However, given the likely strength of saving in much of DM, the increase in real rates may end up being relatively modest.
Note that the dichotomy of ‘good' versus ‘bad' (sovereign) country credits mentioned above translates into different risk premia and real interest rates for the two clubs. High real interest rates for ‘bad' country credits - these will be mostly net debtor countries - will be the mechanism that brings about a deleveraging of these national economies, in our view.
7. Globalisation: Stalling
The increase in macro instability comes at a time of major demographic transition in most DM and many EM economies. As populations become older, the demand for economic security - stable jobs, pensions - increases. This tension between higher instability and increased demand for security is likely to find its political expression in a backlash against globalisation. So far, the benefits of globalisation - higher income levels for most, i.e., the large middle class - have outweighed its drawbacks - increased competition and job instability. This has kept the globalisation show on the road until now. As this balance tips because the preferences of the middle class shift towards more security/stability, globalisation is likely to stall or reverse. The ageing middle class, gradually a larger and larger share of the electorate, could vote for politicians - on the left or on the right - that resist globalisation. A reining in of globalisation would affect those EM economies that are not yet at the stage of transitioning towards domestic demand - i.e., the second EM wave, countries such as Vietnam.
8. International Monetary Regime: Survives
The US dollar has remained the world's reserve currency through the Great Recession, and we don't expect this status to be breached. Given the demise of the Gold Standard and the Bretton Woods arrangement, the lack of a viable alternative suggests that the current international monetary system is likely to survive the financial crisis and the Great Recession. Goods, services and capital will therefore continue to flow relatively easily across countries, but the pullback from globalisation could mean that the intensity of these flows will be lower.
The one aspect of the international monetary regime that could see more change is the move towards a more flexible exchange rate environment. China's move towards a more flexible regime will likely be a watershed event, not just for China. Other AXJ economies that were keen to avoid currency appreciation against the renminbi (and hence also against the US dollar) should also have a freer rein. Where some desire for pegging currency values persists, there will probably be a preference to target a basket of currencies or the trade-weighted exchange rate rather than fix a bilateral exchange rate. Managed floats are likely to remain the most popular exchange rate regime.
9. Global Imbalances: Unwinding
CAs reflect the domestic imbalance between savings and investment. Net savers will run current account surpluses while net spenders will have to deal with deficits. To reduce global imbalances, net spenders have to save more and net savers less. This process is already underway. Eventually, we would not be surprised to see net spenders like the US running CA surpluses. Note that this will likely be true for many other debtor economies as well, e.g., for the countries of the European periphery. With external credit more difficult to raise, these economies face higher interest rates and will need to run CA surpluses in the future.
Net saver economies, easier to find in the EM world, are keen to have higher domestic demand as macro insulation against external shocks. This should lead to greater trade flows going forward, probably enhancing intra-EM trade greatly. The result will likely be a different pattern, but still a mix, of current account surpluses and deficits going forward. The successful role that FX reserves played in weathering the recent crisis means high reserves should remain a feature in EM world, reducing its vulnerability to the flow of capital and trade.
Going forward, large CA imbalances will be less likely. Real exchange rate appreciation in the EM world will probably keep surpluses from widening too much there. Excessive spending in the net spending DM world will likely be expensive because net savers will want to be compensated for the risk from such spending, given the events of the last few years. Running large deficits driven by excess spending would therefore be more expensive and less likely, in our view.
10. DM versus EM
The significantly better outlook for EM growth is firmly entrenched as conventional wisdom. There are very few reasons to question that outlook. If anything, the uncertainty surrounding the growth outlook in much of the DM world, particularly the euro area economies, only serves to reinforce the appeal of the EM world. Effectively, the risks attached with debt, inflation and therefore growth make the risk-adjusted return in the EM world even more attractive.
The challenges facing DM economies are very clear and equally difficult, but EM economies have work to do as well. High indebtedness, lower trend growth and the growing risk of higher inflation is an unenviable combination for DM policy-makers to deal with. EM policy-makers also have work to do. They know that they need to further reduce the risk that stems from political and legal institutions as well as the financial stability risks that will likely accompany the expected rapid growth in domestic financial markets.
However, while the problems facing DM economies are in the price, the recent outperformance by the EM world shouldn't mean that risks to EM can be ignored. While they were able to avoid a serious downturn over the last couple of years, this shows their ability to insulate themselves from a massive shock to the DM world. In the future, EM economies may need to demonstrate their ability to bounce back from shocks to their domestic economies which could prove to be more challenging. Lessons from past EM crises have clearly been learned, and those learnt from the recent financial crisis should provide an invaluable roadmap for other mistakes to be avoided, in our view.
Euroland: Heading for Make or Break?
2011 Is Likely to Bring a Mild Moderation in GDP Growth...
The recovery will likely continue to be below-par, bumpy and brittle and can be still characterised as largely creditless, mostly jobless and very uneven. At an average 1.5%, on our forecasts, headline GDP will likely slow slightly from 1.7% last year. This would still be above the current potential growth rate, which we estimate at around 1%. And, in the light of the sovereign debt crisis, this would still be a good outcome. Nonetheless, growth will likely remain below the historical trend of around 2%. The main reasons for the mild moderation in GDP growth are the removal of the fiscal stimulus in the two largest countries, further fiscal tightening in the periphery and a deceleration in global trade growth. More generally, the recovery should stay subdued because of the ongoing need to deleverage balance sheets across all sectors and the negative impact of the financial crisis on potential output growth - i.e., the speed limit for inflation-free GDP growth over the long term. It will thus take until the second half of next year before the euro area will have even made back the output losses of the 2008-09 recession, we estimate. And it will take considerably longer before it regains a normal level of resource utilisation, thus allowing the ECB to keep rates unchanged.
...but the Recovery Should Continue to Broaden Out
In terms of the drivers of growth, the euro area has already witnessed a shift away from inventory rebuilding and rising exports towards stronger final domestic demand in the course of last year. We expect this broadening of the recovery to continue in 2011, and forecast overall investment spending growth to turn positive again, as capex keeps motoring ahead at moderate rates and construction no longer contracts sharply. Meanwhile, consumption growth should expand steadily at a subdued rate. But the aggregate steadiness masks substantial country differences between Germany and France (where spending is recovering noticeably in the former and remaining strong in the latter) and in parts of the periphery (where it is still contracting). Given fiscal tightening across the EMU, government consumption should flatline.
Alas, the Recovery Will Generate Few New Jobs
True, there are signs of a stabilisation in the unemployment rate and in payrolls too. But we expect the improvement in hiring intentions seen in the last few months to peter out soon. Our employment indicator is already pointing towards a moderation. The sluggish labour market response reflects three main factors. First, the subdued nature of the recovery and the low level of resource utilisation. Second, labour hoarding during the recession (Germany, France, Netherlands). Third, permanent job losses in construction and real estate (Spain, Ireland). As a result, wage increases will likely be moderate, thus helping keep unit labour costs low. Despite these modest underlying inflation pressures, headline HICP inflation is on the rise at the moment. Unusually cold winter weather has already pushed inflation past the ECB price stability threshold of 2% for the first time in two years. Further temporary increases driven by commodity prices and indirect tax hikes might lie ahead.
EMU Budget Deficit Narrows, Government Debt Still Rises
Recovering domestic demand, a stabilising labour market and discretionary fiscal tightening should bring the deficit from 6.3% of GDP to 4.8% in 2011, implying a discretionary fiscal tightening of about 0.8% of GDP for the euro area as a whole. Again, there are very big differences between individual countries both in terms of the level of the budget deficit and its change compared to 2010.
In Our Base Case, the ECB Continues to Gradually Withdraw its Unconventional Measures but Leave Rates Unchanged
The withdrawal of monetary policy stimulus started with the ongoing phasing-out of the LTROs with a maturity of more than three months. In our view, it will gradually switch the refi tender operations back from fixed-rate, full allotment to a variable-rate auction. The switch in the tender operations will probably happen in increments, starting with the three-month tenders and ending with the weekly operations. On the whole, the interbank market in the euro area seems to be functioning better now. However, behind the overall improvement, trouble spots are still likely to lurk - both in terms of the variance in national banking systems' reliance on ECB funding and in terms of the variance between individual institutions within those banking systems.
Ideally, the ECB Would Want to See Financial Stability Issues Being Addressed before Embarking on a Tightening Cycle
If needed, however, the bank could also raise interest rates before it is has completely phased out all unconventional measures (see EuroTower Insights: Executing the Exit, November 11, 2009). But despite the current inflation overshoot, we expect the ECB to stay put for the whole of 2011. Yet, in the light of the improving growth backdrop globally, rising headline inflation and potentially also rising inflation expectations, we see an increasing risk that the ECB cannot afford to wait until 2012 for its first rate hike. In the absence of an early ECB rate hike, however, the monetary policy backdrop would argue for steeper curves, led by a sell-off in longer maturities. We expect 10-year Bund yields to rise from 2.9% at the time of writing to 3.4%.
Risks to Growth Outlook Are Broadly Balanced, Non-Quantifiable Uncertainty Remains Elevated
Potential upside surprises to growth could stem from stronger-than-expected global growth momentum, from a more pronounced weakening in the euro's exchange rate, and from positive effects on confidence as governments address the sovereign debt crisis. Possible downside surprises to the growth outlook could stem from limited credit availability due to weak balance sheets (both of lenders and of borrowers), from a further rise in the already elevated energy and commodity prices, and from renewed bouts of financial market tension - pushing funding costs higher and causing liquidity to dry up. In addition, the volatility/uncertainty created by the sovereign debt crisis itself could cause hesitation in investment spending. Finally, a global inflation scare could cause bond markets to sell off broadly.
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