A Long Economic Expansion
September 23, 2014
Our outlook is for a long global and U.S. economic expansion. The global economy has been expanding over the last half decade. For the past few years, however, it has only grown at roughly a trend growth rate. As a result, consumer price inflation has been moderate in most developed countries and too low in others. This has allowed many central banks to remain easy. Economic expansion since the Great Recession has been relatively moderate in each of the major regions, which has permitted yields to remain depressed.
We expect that a key theme in the global economy will be monetary policy divergence, with some central banks remaining easy and others gradually normalizing interest rates by future monetary policy tightenings. However, monetary policy divergence is not the only kind of divergence in the global economy. There are global divergences of (1) output gaps, (2) real growth, (3) inflation, (4) real interest rates, (5) real exchange rates, (6) energy sensitivities, (7) stage of the debt cycle, (8) competitiveness, and (9) policy credibility. Currency markets can be a mechanism for redistributing growth and inflation within the global economy. Currency changes can either mitigate global imbalances or exacerbate them. Fortunately, the recent pattern has been supportive of a rebalancing of global growth and inflation. Especially among the developed countries, currencies of countries with weak underlying growth and disinflationary tendencies (such as the Eurozone countries) have been weak, while currencies of countries with stronger growth (such as the U.S.) have been strong. Expectations of future monetary policy divergence have been generating favorable trends in currency divergence.
We expect a prolonged global and U.S. economic expansion. Stimulative monetary policy has generated only sluggish growth so far in this expansion due to a partially offsetting combination of drags from (1) fiscal tightening, (2) private sector deleveraging, and (3) restrictive financial regulation. A substantial degree of fiscal tightening has already occurred in most developed countries. With the probable exception of Japan, fiscal tightening is likely to prove less of a drag over the next several years. In a context of very low interest rates, a substantial improvement in private sector debt service burdens has already occurred, especially in the U.S. household sector. We believe that there has been an oversteering cycle in financial regulation, swinging from too loose to too tight. We believe that the current setting of financial regulation is not very growth supportive. Restrictive regulation is unlikely to be eased, but the financial system should gradually adjust to this more restrictive regulatory regime over the next several years. This is likely to lead to an eventual pickup in those forms of credit growth which support real economic growth and not just those forms of credit growth which finance the transfer of existing assets. With a reduction in the fiscal drag and the deleveraging drag, combined with the gradual adjustment of the financial system to restrictive financial regulation, some acceleration in the pace of U.S. economic growth is likely.
We continue to expect an eight-year economic expansion in the U.S. We believe that the U.S. economy has just made an upward shift from a half decade of expansion at a real GDP growth rate slightly above 2% to three years of 3% real GDP growth. We expect nominal GDP growth (real GDP growth plus inflation) to accelerate to about 5% for the next several years.
Global inflation has been moderate in a context of sluggish global growth. Underlying inflation is below the target of all four of the G4 central banks (the Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan). Our expectation is that underlying inflation will drift higher to or above target over the coming years in both the U.S. and the U.K. The underlying inflation rate in Japan should eventually rise to the Bank of Japan’s target over a period of years.
Driving Eurozone inflation back up to the ECB’s target is likely to be a major struggle, with additional fiscal, monetary and structural reform actions likely to be needed over the coming years. The fundamentally poor design of the euro system is hampering the transmission of monetary policy. Reported inflation in the Eurozone is only slightly above zero and core inflation is below 1%. While we believe that Eurozone inflation is at its extreme bottom, the Eurozone faces below-target inflation for several years to come, given excess capacity and an inefficient monetary transmission mechanism.
Inflation in the U.S. appears to have bottomed and is drifting upwards towards the Federal Reserve’s target. Service inflation is beginning to reflect tighter labor markets although weak foreign economies and a strong dollar are restraining goods inflation. Inflation in the U.K. is still somewhat below the target of the Bank of England. While Japanese inflation has been drifting higher, underlying inflation (net of the Value-Added Tax increase) is still below the Bank of Japan’s target.
The G4 central banks have attempted to anchor medium-term consumer price inflation and long-term inflation expectations near 2%. Major deviations of underlying inflation or long-term inflation expectations from target have motivated them to aggressive action. The ECB’s prior belief that Eurozone inflation expectations were well-anchored did not prove to be correct, as inflation expectations have weakened. It is notable that the recent ECB easing included a focus on both a lower euro and on a promised expansion of the ECB’s balance sheet after a period of passive contraction. These can be viewed as channels to resist the decline in both consumer price inflation and long-term inflation expectations in the Eurozone. The Federal Reserve adopted QE1 and QE2 when longterm inflation expectations were dropping and threatened to slip anchor. One reason the Federal Reserve has been comfortable holding the Federal funds rate near zero, even after more than a half decade of economic expansion, is that U.S. inflation expectations have been restrained. Long-term inflation expectations in the U.S. are currently slightly below their average level in recent years.
Why are yields low in the G4 countries (the U.S., the UK, the Eurozone and Japan)? A primary reason is that the Great Recession created excess capacity in the goods and labor market. Inflation has been held down by this excess supply, often labeled an “output gap.” Given this unused capacity, central banks have been motivated to stimulate the economy by: (1) holding short-term interest rates down near zero and (2) directly manipulating down long-term bond yields by purchasing sovereign bonds in the quantitative easing programs of the Federal Reserve, the Bank of England and the Bank of Japan. In the Eurozone, interest rates dropped in a context of economic weakness and disinflation while peripheral spreads narrowed following the promise of “whatever it takes” by ECB President Mario Draghi. Low interest rates in the developed world resulted from a combination of (1) large output gaps (excess capacity), (2) a moderate pace of economic recovery, (3) low inflation, (4) central bank policy rates set low in both absolute terms and relative to inflation, and (5) an engineered scarcity of safe sovereign bonds available to the private sector via quantitative easing in the U.S., the UK and Japan.
Over the next several years, the G4 central banks are likely to split into (1) the “normalizing central banks” (the Bank of England and the Federal Reserve), where economic expansion appears strong enough that short-term policy rates should begin to rise in 2015 and (2) the “ZIRP central banks” (the European Central Bank and the Bank of Japan). ZIRP stands for “zero interest rate policy,” which is likely to persist at the ECB and the Bank of Japan for several years.
We believe that the ECB’s action in early September was the last of the G4 interest rate cuts, likely to be followed in 2015 by the onset of policy rate hikes in the U.K. and the U.S. In our opinion, the final easing action of the Federal Reserve was its modification of balance sheet guidance. We believe that this change in balance sheet guidance contributed to the bond market rally in the first eight months of 2014. The Fed’s original “exit strategy” guidance in June 2011 was that it would halt the reinvestment of maturing bonds into new purchases prior to its first interest rate hike. It has withdrawn that guidance. The new guidance is that the Federal Reserve will be slow to reduce its bond portfolio, retaining a large balance sheet for many years rather than quickly reducing its bond portfolio. However, the impending end of quantitative easing does mean that the supply of Treasury bonds available to the private sector should finally begin to trend higher over the next several years.
The monetary policy divergence between the “normalizing central banks” and the “ZIRP central banks” is likely to contribute to a basic dollar uptrend over the coming years. We believe that the recent weakness in the euro and the yen should aid in an appropriate global redistribution of growth and inflation. It is favorable for global balance when those countries most challenged by economic weakness and deflation risks experience currency weakness while those countries with strong demand growth experience currency strength. Over the next several years, an upward drift in underlying inflation in Europe and Japan in the context of low nominal yields should help lower real yields (yields net of inflation) and support positive economic growth. Divergent monetary policy between the “normalizing central banks” and the “ZIRP central banks” should be characterized by both (1) a widening of interest rate spreads as U.S. and U.K. rates rise and (2) a shift in the relative growth of central bank balance sheets. The U.S. dollar should also benefit from the major upsurge in the production of oil and natural gas in the U.S. This has helped U.S. economic growth and lowered the U.S. current account deficit. Because of the rise in domestic U.S. oil and gas production, the U.S. now needs to borrow much less from foreigners than it did in the past decades.
The low level of sovereign bond yields in the major developed countries has also been due in part to a scarcity of “safe” sovereign bonds available to the private sector. This has multiple causes. First, the global financial crisis shortened the list of countries whose sovereign bonds were viewed as safe. Second, there was a fiscal tightening in each of the G4 regions, which restrained the pace of economic recovery and tended to lower the expected future need for deficit financing. Third, international reserves continued to grow. Thus the demand for safe sovereign bonds increased among reserve managers with inflows to invest. Fourth, some high quality bonds have been used to permanently hedge future pension liabilities. Fifth, central banks phased in requirements that commercial banks hold an increasing share of their portfolios in investments that the regulators regarded as safe. Sixth, three of the G4 central banks (the Federal Reserve, the Bank of England and the Bank of Japan) adopted quantitative easing programs designed to manipulate long-term bond yields below their free-market levels by reducing the supply of sovereign bonds available to the private sector. It is conceivable that the European Central Bank might do the same if European conditions deteriorate badly enough, but opposition by Germany may lead to expanded efforts to buy various kinds of private sector assets instead. Overall, our most likely case is that a gradual easing of the artificial scarcity of the highest grade bonds should contribute to a gradual upward drift in bond yields over the coming years as the output gap is gradually reduced.
It is clear that the path of the U.S. labor market will strongly influence the timing and pace of the Fed’s normalization of the Federal funds rate. Our view of the U.S. labor market is that (1) there is still a pool of excess labor supply (slack) in the U.S. economy, (2) the degree of slack is dropping persistently,month after month, (3) the tightening labor market is likely to generate moderately rising wage inflation over the next several years, (4) the speed of wage acceleration is likely to be gradual, with wage inflation likely to drift higher rather than surge higher, (5) an upward drift in wage inflation should support real income growth, (6) an upward drift in wage inflation is likely to be tolerated or welcomed rather than resisted by the Obama Administration, the Federal Reserve and the general public, (7) the rise in the Federal funds rate should be gradual, and (8) a gradual normalization of interest rates should not disrupt the acceleration in the pace of economic growth we expect.
The growth in labor demand continues to exceed the growth in labor supply. A recent working paper by the Federal Reserve staff entitled “Labor Force Participation: Recent Developments and Future Prospects” reviews the issue of whether the fall in the U.S. participation rate is more attributable to sustained structural trends or to the effect of a temporary cyclical weakness in labor market demand. Their basic conclusion was that the decline in the participation rate was mostly structural. Thus the downtrend in the participation rate is unlikely to be reversed in a major way by continued economic improvement. As a result, a continued fall in the unemployment rate should motivate a shift to interest rate normalization at the Federal Reserve. Our current most likely case is that the first rate hike should occur in mid-2015 and that the Federal funds rate should then drift gradually and persistently higher, initially rising 25-basis-points quarterly. This is likely to occur at every other meeting of the FOMC, the ones with a press conference.
The massive excess reserves in the banking system in the context of a multi-trillion dollar Fed balance sheet have shrunk the size of the Federal funds market since there is negligible demand to borrow reserves to meet reserve requirements. For this and other reasons, the structure of the money markets has changed dramatically. Uncertainty about how smoothly Fed tightening will work in this new system is likely to motivate a cautious pace of tightening by the Federal Reserve, at least initially. We expect that a slow pace of tightening shouldcause Federal Reserve policy to eventually fall “behind the curve” over the next several years, resulting in an interest rate spike in 2017 or 2018. After a three-decade long 1,463-basis-point decline in 10-year Treasury yields from 16% on September 30, 1981 to 1.37% in late July, 2012, 10-year Treasury bond yields are now almost double their extreme cyclical and secular low of 1.37%. Following the bond market rally in the first eight months of 2014, we expect the uptrend to resume. U.S. bond yields are already tracing out a pattern of higher lows and a pattern of higher highs should eventually follow.
The logical consequence of the prolonged economic expansion that we expect is that excess capacity should be gradually reduced over time. Bond yields should drift higher in those countries with “normalizing central banks.” This should generate a “coupon-minus” pattern in the bond market over the next several years in those countries, as an upward drift in interest rates should be accompanied by a downward drift in bond prices. That is already starting in those countries, including the UK and the U.S., which are expected to begin to normalize their central bank policy rates in 2015. We expect that interest rate normalization should prove to be a multiyear process in most developed countries, gradual enough that it will not disrupt sustained economic expansion. The fundamental cause of an upward drift in interest rates is likely to be a reduction in excess capacity as real growth continues, not an upsurge in excessive inflation. While episodes when soaring inflation drives up interest rates can be a prelude to a credit crunch and recession, appropriate interest rate increases in response to faster real growth can extend the duration of economic expansion by preventing the buildup of imbalances.
What could go wrong with our outlook for a long economic expansion? In the past decades, sharp spikes in oil prices due to supply shocks have often helped trigger a recession. While geopolitical stresses in the Middle East and Ukraine do create concerns, a major energy supply disruption still appears unlikely in the current context. Most Iraqi oil production is distant from the fighting. There are worries that the conflict over Ukraine could reducenatural gas supplies from Russia to Europe this winter. It would be reasonable to expect threats that the flow of natural gas to Europe could be reduced this winter, as well as some episodes of short disruption. However, we doubt there will be any major sustained supply shock, as both Russia and Europe will need to rely on the trade in natural gas for years to come. Transportation inflexibilities in the flow of natural gas constrain both the supplier and the customer. The strong growth in oil and gas production in North America and excess coal capacity worldwide are likely to limit the global spillover from any short episodes of gas supply disruption in Europe.
Some analysts are concerned that property weakness in China could create a financial meltdown. While we do believe that China is undergoing a permanent downward shift to a slower sustained growth rate, we believe that the Chinese government has both the resources and the willingness to intervene to avoid a financial meltdown.
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. The latter is what we expect. We believe that the shifting growth mix in China has lowered the risk of an oil price spike which might threaten the global economy.
Our basic outlook continues to be that low inflation permits easy monetary policies which will support “a long economic expansion.”