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To the Point, October 27 2009

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To the Point, October 27 2009

  1. 1. To the Point Discussion on the economy, by the Chief Economist October 27, 2009 Cecilia Hermansson Chief Economist Swedbank Economic Research Department +46-8-5859 1588 cecilia.hermansson@swedbank.se No. 1/2009 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 outlook for price developments. At the centre of the analysis, are the issues of exit strategies, regulation and macro economic imbalances. Ultimately, timing will be the key. Will global leaders make necessary regulatory changes in time? Will these leaders find the exact time to pull back stimulus measures? The world has not become 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 • continuing but slow deleveraging.
  2. 2. To the Point (continued) October 27, 2009 2 Many markets are being manipulated In the US, employment is falling and productivity is increasing … … but Germany has taken the opposite route Watch out for lower potential growth! Chart 1: Industrial production and leading indicators in the OECD Source: Reuters EcoWin 85 87 89 91 93 95 97 99 01 03 05 07 Percentagechange -20 -15 -10 -5 0 5 10 Industrial production in the OECD OECD Leading indicators Deflationary risks have abated, but can not be completely ruled out It makes sense creating four growth and price scenarios In the medium to long term, i.e., after 2010-2011, the task of maintaining 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 “real” price developments. 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 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. 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 adjustment. In the medium to long term, the clouds get darker. The expected loss in global 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, 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 labour markets’ weakening, the financial sector’s shifting into reverse, and globalization’s slowing. Policy could make a difference – watch out for protectionism and long-term unemployment! The OECD has lost 10 years of industrial production due to the financial crisis and the recession. Leading indicators and Purchasing Managers’ Indexes show improvements – the recovery is starting. However, it will take a long time – several years – to get back to the pre-downturn 2008 level. Why there are risks for deflation – but also for 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, as well as in many other parts of the world, the current situation could still be 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. “No growth” is basically negative or very weak growth, below potential, 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).
  3. 3. To the Point (continued) October 27, 2009 3 Chart 2: Growth and price scenarios Deflation Inflation Growth X No Growth The withdrawal of stimulus come in three steps: 1) Absorb liquidity and stop unconventional monetary policy 2) Increase interest rates and use conventional monetary policy 3) Increase taxes and cut spending to start consolidating budgets and reduce public debt Chart 3: Central banks’ policy rates Source: Reuters EcoWin 00 01 02 03 04 05 06 07 08 09 Percent 0 1 2 3 4 5 6 7 Sweden US Euroland UK Japan 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 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 growth and inflation – or even worse – east into no growth and inflation, i.e., stagflation. 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 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 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 mortgage- backed securities without hurting the recovery on the housing market. With credit easing and quantitative easing employed as unconventional policies, exit strategies must include both interest rate hikes 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 crisis. 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 OECD will reach all-time highs and stay there for a long time. Real interest rates could increase when problems of crowding out start to be visible. 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 output gaps, and we can not rule out inflation also in a situation where there is ample capacity. Confidence in central banks’ independence and their commitment to maintaining price stability is important. This is also why it is important to make clear on the exit strategies, without hurting the recovery process helped by the stimulus measures. Will governments and central bankers succeed in exiting in the right way and at the right time? Central banks can raise interest rates on banks’ reserves at the central banks. Government bonds and other assets can be sold. Repo rates can be increased. And it will be important to coordinate monetary and fiscal 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!
  4. 4. To the Point (continued) October 27, 2009 4 Financial markets have a tendency to create bubbles Moral hazard is one of the serious side-effects of this financial crisis and the problem of too big to fail has increased Timing may not be right to start the anti-bubble strategy – but regulatory changes must come when the recovery is in place Chart 4: The Euro, Yuan and Yen against the US dollar (Index 100 = 2007) Source: Reuters EcoWin 98 99 00 01 02 03 04 05 06 07 08 09 70 80 90 100 110 120 130 140 150 160 170 Yen against the US dollar Euro against the US dollar Yuan against the US dollar The right time for regulatory changes 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 likely – neither political nor economic reality would allow it. 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 the bubbles have burst, financial institutions can always count on being saved from collapse. 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 will have come. The main goal should be to increase the prospects for financial stability, while maintaining the focus on price stability. This will require a shift in thinking in central banks – away from a partial analysis of consumer price inflation targeting and towards a reliance on a more holistic framework. It has to come – it’s all about timing! Does the US and China need marriage counseling? One of the lessons learnt during the crisis is the need to fix macroeconomic imbalances between the US (and other current account (C/A) deficit countries) and China (and other C/A surplus countries). The US C/A deficit has been sliced in half to some 3% of GDP, but China continues to increase its surplus. In addition, if economic policy is not changed – which it has not, as the US gives cash for clunkers to boost car consumption and China supports export developments and keeps the exchange rate pegged to the US dollar – a large C/A deficit in the US will return again after some years.
  5. 5. To the Point (continued) October 27, 2009 5 Chart 5: GDP-growth in China, India, Sweden, Euroland, Germany, Japan and the US (%) Source: Reuters EcoWin 00 01 02 03 04 05 06 07 08 Percent -10.0 -7.5 -5.0 -2.5 0.0 2.5 5.0 7.5 10.0 12.5 15.0 Japan Euroland Sweden India Germany US China Economic Research Department SE-105 34 Stockholm, Sweden Telephone +46-8-5859 1000 ek.sekr@swedbank.com www.swedbank.com Legally responsible publishers Cecilia Hermansson +46-8-5859 1588 Or perhaps the China-US “marriage” is not working after all? Both parties 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 exacerbate both US fiscal problems and risk a much weaker dollar. China builds capacity as perhaps 75% of growth now comes from investment financed to a large extent by the public administration. US is still an important export market for China. There is an understanding that both countries need a more balanced growth. This does not mean it will happen. To increase consumption in China, social security must be developed including through pensions and reasonable tuition and health fees. To open up capital markets and liberalize the foreign exchange system will be a challenge, as the risks for financial instability increase and lower export prospects create potential for both political and social instability. The most likely scenario is a slow pace of appreciation, a process that will start again when world demand is growing more solidly. Meanwhile, the expectations are asymmetrically geared towards appreciation – 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 To the Point is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in To the Point.

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