Wednesday, August 27, 2014

Draghi's "call to action"

Much of the discussion around  European Central Bank president Mario Draghi’s speech at the recent Economic Symposium at Jackson Hole has centered on the extent to which it was – or wasn’t – dovish.  I think it was undeniably dovish but dovish within the harsh reality that there is only so much monetary policy can do.  I think the speech is better described as an important “call to action” for a helping hand from fiscal policy and structural reform.

Since the Global Financial Crisis, and with respect to the Euro zone the sovereign debt crisis also, I’ve made a number of observations from time to time about the challenges of raising potential growth rates that were damaged through the Great Recession.  Foremost amongst those observations is the fact (yes, fact) that improving potential growth is predominantly a structural issue.  The role for monetary policy is to support demand and, where necessary buy time for the more important structural reforms to be implemented.

The challenges in the Euro zone are unique and more problematic to the extent that that necessary improvement in external competitiveness in many countries, notably “the periphery” has been constrained by a fixed exchange rate.  That means the adjustment has had to come via wages and employment.  High rates of youth unemployment in many Euro zone economies will ultimately prove to be one of the biggest social crises of our time.  Melodramatic?  I don’t think so.

Progress has been made in reducing large structural budget deficits but at considerable economic cost.  Debt  to GDP ratios have a numerator and a denominator.  Harsh front –loaded austerity measures have thus far done more to damage the denominator than improve the numerator!  Finance sector deleveraging has, and will continue to constrain credit growth.  Of the measures announced in June by the ECB the TLTRO is most likely to have an impact on credit growth although greater supply of credit does not itself create demand.

All that said there are a number of worthy suggestions in Draghi’s speech.  Firstly, he believes “it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy”.   He acknowledges the constraint that levels of government spending and taxation in the euro zone are already amongst the highest in the world.   A while be also believes it would be self-defeating to break the rules of the Stability and Growth Pact, he states the existing flexibility within the rules could be used to better address the weak recovery and to make room for the cost of needed structural reform.  Couldn’t agree more.

Secondly Draghi states “No amount of fiscal or monetary accommodation, however, can compensate for the necessary structural reforms in the Euro area.”  Couldn’t agree more (2). He believes that the reform agenda should span labour markets, product markets and actions to improve the business environment. 

He goes on to highlight two areas of labour market reform he sees as priorities - policies that allow workers to redeploy quickly to new jobs and raise the skill intensity of the workforce.  You guessed it: Couldn’t agree more (3).

This was an important speech, well beyond its implications for monetary policy.  I still think economic conditions will eventually see the ECB implement a more fulsome program of asset purchases.  But, again, all that will do is buy time for the more important growth enhancing work to be done.  Without that the Euro zone appears destined for a very long period of very low growth.  Call it secular stagnation if you like.

Friday, August 22, 2014

The PrEFU, PMIs and the FOMC

I’ve been a bit of a lazy blogger this week so this is a bit of an “omnibus” post on the key events of the week (at least according to me!) - the PrEFU in New Zealand, the latest flash PMI results from around the world and the release of the minutes from the July FOMC meeting.

Starting at home the Pre-Election Economic and Fiscal Update (PrEFU) contained little in the way of surprises.  The Treasury has knocked a bit off their near-term growth estimates reflecting weaker dairy prices, offset to some extent by stronger net migration.  This has brought their forecasts closer to ours.  Like us they believe the New Zealand economy is past the peak in quarterly growth rates although our numbers are still a tad softer than theirs – but we’re talking about a difference of 0.1% per quarter on average.

The lower growth numbers has had a small impact on the key fiscal indicators over the forecast horizon but the underlying trend improvement in the operating balance and debt ratios remains unchanged.  The Treasury is still expecting the return to fiscal surplus to be achieved in 2014/15.

Importantly from the perspective of the Reserve Bank, fiscal policy remains contractionary over the forecast period with an average fiscal impulse of -0.4% per annum, unchanged from the Budget.


The Government continues to keep its fiscal powder dry – there was no news in the PrEFU on how they intend to use their new initiative allocation.  That means they go into the business end of election campaign with their fiscal options open.   That said the National Party campaign launch is this weekend so we may see some policy shots fired there.

Further afield we saw the latest round of flash manufacturing PMI’s from Markit this week and they were a bit of a mixed bag.  The good news was the surge higher in the US index to 58.0 in August from 55.8 in July.  That’s its highest reading since early 2010 and supports our expectations of stronger US growth in the second half of the year on the back of further gains in employment underpinning solid consumption growth.

The Japan index also rose over the month from 50.5 to 52.4 supporting the view that growth will resume in the third quarter after the bigger-than-expected contraction in the second quarter.  But with a return to trend growth in Q4, that still only delivers annual average growth of around 1.0% this year.


The China and Euro zone indices were disappointing.  The slip in the China index from 51.7 to 50.3 along with the recent softness in the some of the July activity data has effectively removed the bias towards upside risk to growth in the second half of the year.  We think GDP growth tracks around 7.4-7.5% for the rest of the year, supported by likely further tweaks to fiscal and monetary policy settings.

The Euro zone remains the problem child in the global economy.  Disappointing Q2 GDP growth is being followed with weakness in Q3 activity data.  The manufacturing PMI fell from 51.8 to 50.8 over the month, a 13-month low.  While we expect reduced fiscal drag, easier monetary conditions and a weaker Euro are collectively expected to keep the Euro zone from slipping back into recession, it’s no surprise the secular stagnation stories are starting to reappear.  More on the Euro zone next week.

Finally this week the minutes from the July FOMC meeting were interesting on a couple of fronts.  A discussion around the slack in the labour market revealed that the majority of meeting participants thought the recent improvement in the labour market had been faster than expected and that “conditions had moved noticeably closer to those viewed as normal in the longer run”. 

At the same time Staff forecasts showed a downward revision in their estimate of potential GDP, the natural conclusion from which is the output gap is now smaller than it was before and that all else being equal the Committee is getting closer to tightening monetary policy.  There was also a discussion at the meeting on the stimulus exit strategy. 

Those discussions were entirely appropriate for this stage of the cycle and there was nothing in any of this to change my view that QE will be finished in October but no rate hikes to mid next year.  Janet Yellen’s upcoming speech at the annual monetary symposium in Jackson Hole might add further colour...but then again it might not.  Mario Draghi is also speaking so watch out for that.

Friday, August 15, 2014

Growth in the Euro zone and Japan

The two economies that have caused me most consternation so far this year have been the Euro zone (more precisely France and Italy) and Japan.  Both reported June quarter GDP this week and neither failed to deliver on low expectations.  But don’t expect a rush to action from either the European Central Bank or the Bank of Japan.

Japan activity data has been volatile recently around the increase in consumption tax that was implemented on April 1st.  The March quarter benefitted from strong pre-tax hike spending which saw GDP expand at an annualized rate of +6.1% only for the economy to give back more than that gain in the second quarter with a contraction of -6.8%.  While that result was a tad better than the consensus forecast, those forecasts had been lowered sharply following the release of weaker-than expected June partial data a couple of weeks ago.

The detail of the result was weaker than expected with a larger than forecast decline in consumption of -5.0% (not annualized!!) and a +1.0 percentage point contribution from private inventory accumulation.  The weak consumption number supports our assertion that consumer spending in Q2 would not only suffer from the payback from Q1 but also from the reduction in real incomes.  Exports were also disappointing but a large drop in imports led to a better than expected positive contribution from net exports.

Looking ahead the consumption result was so weak there must be a bounce back the other way in Q3.  That said, inventories will probably be a drag on growth the next quarter.  I’ve bumped up my Q3 forecast to an annualized 3.5% followed by a return to around trend in Q4.  That results in annual average growth of 1.1% for the calendar year.


Euro zone GDP was unchanged in the June quarter.  Germany was weaker than we were forecasting (-0.2% q/q) while Portugal (+0.6% q/q) the Netherlands (+0.5%) and France (no change) were better than expected.

I’m less worried about the result from Germany.  The Q2 result appears to be a bit of payback from the strong good-weather-related Q1 result.  But I continue to be concerned about the outlook for both France and Italy (the serial non-reformers).  Both will remain a drag on overall Euro zone growth.

I don’t expect the Euro zone to slip back into recession.  Highly stimulatory monetary conditions, lower fiscal drag and a gradual recovery in global growth should see recession avoided.   But I also don’t expect anything near robust growth in the second half of the year.  Our forecast of only modest growth in the second half of the year is expected to result in annual average growth of 0.8% for calendar 2014.


Neither the Bank of Japan nor the European Central Bank are likely to respond to the latest news with new stimulus any time soon.  But there is still a chance they will do more later in the year.  For Japan the key to further monetary policy action is how growth plays out in the in the second half of the year – so it’s still too early.

The ECB undertook new stimulus measures in June including the new TLTRO program.  We expect they will want to wait to see what impact that has before deciding on the need for any new measures.  Also the Euro is now lower which will contribute to higher inflation. We expect this will accelerate once the Fed starts to raise interest rates and we see a stronger USD – but that’s a story for next year.

Wednesday, August 6, 2014

NZ labour market...and dairy prices

June quarter New Zealand labour market data was weaker AND stronger than expected: weaker due to lower than expected employment growth but stronger with a bigger than expected fall in the unemployment rate.  Wage growth also came in a tad stronger than expected.

Employment growth came in at 0.4% for the quarter, lower than our expected 0.6%.  That result for the quarter put the annual rate of growth at 3.7% for the year – still a pretty good result.  The unemployment rate fell to 5.6% over the quarter, lower than our forecast of 5.8% and down from the revised March level of 5.9%.  The bigger than expected decline in the unemployment rate was courtesy of a fall in the participation rate.


Wage growth came in a tad stronger than expected but after allowing for the recent increase in the minimum wage didn’t signal any meaningful increase in wage inflation.

By itself this data suggests a prudent course for monetary policy would be for interest rates to push on towards neutral.  But that would mean ignoring another large fall in dairy prices overnight.  Prices fell another 8.5% in the latest auction, taking the cumulative fall since February to 41%.  While the NZD has moved lower, it has still not adjusted sufficiently given the fall in commodity prices.

We had expected dairy prices to be weaker this year.  This has been a factor in our view that we have already passed the peak in quarterly GDP growth rates.   But dairy prices have ended up being considerably weaker than we expected which has shifted the risk to our growth forecasts to the downside.  At the very least this justifies the RBNZ's signaling of a cup of tea to assess where to from here.  More on the growth and interest rate outlook soon.