Changing policy mix to exacerbate 2019 slowdown

  • The global policy mix is shifting from loose monetary/tight fiscal to loose fiscal/tighter monetary
  • This will exacerbate the 2019 slowdown already heralded by monetary data
  • Financial assets will suffer

For much of the post-Great Recession era, economic policy in most major economies has been characterised by a mix of tight fiscal policy (‘austerity’) and loose monetary policy.

Broadly speaking, these policies worked well. That is to say, government primary balances generally improved, after having deteriorated sharply in the immediate aftermath of the Great Recession. Overall, with the significant exception of the United States, they are forecast to improve further in 2019. For the OECD as a whole, the general government primary balance went from -1.9% of GDP in 2008 to -6.6% in 2009, and then narrowed to near balance (-0.2% of GDP) by 2017. For this year and the next, the deficit is forecast to widen somewhat again, but only to -0.8% of GDP by 2019. For the Euro Area, the equivalent numbers are a primary balance of 0.4% of GDP in 2008, moving to -3.8% of GDP in 2009 and 2010, then moving back into surplus by 2016 and forecast to exceed 1% of GDP by 2019 (all data from the OECD Economic Outlook 2018, vol I). Other advanced economies follow a roughly similar trend, although the details may differ.

At the same time, broad money growth generally accelerated, although varying by economy. World broad money growth (excluding China, which implemented a major monetary stimulus in 2008) slumped from 8% in 2007 to -0.9% in 2010, but then recovered to 5.1% in 2017.[1]

The faster broad money growth resulted in stronger economic activity, as most of the world’s largest economies began to recover. OECD GDP slumped by 3.5% in 2009 but growth has since averaged slightly more than 2%; world GDP growth (also measured by the OECD) has been slightly higher but on a similar pattern. Within the OECD, the US economy has grown faster than the European ones, with Italy in particular disappointing among major economies.

In other words, in the combination of a tight fiscal policy and a loose monetary policy, it was the loose monetary policy that dominated and drove a global recovery.

At the same time, substantial spare capacity almost everywhere meant that, in spite of above-trend growth (and trend growth rates had also come down), inflation remained quiescent.

However, this policy mix now looks set to change. There is a global reaction against ‘austerity’. While again, the strength of this reaction varies from country to country, it is broadly based. The United States has enacted a major fiscal stimulus. (Ironically, given President Trump’s fixation on the trade balance, stronger growth in the United States is likely to widenthe trade deficit, regardless of his tariffs.) The British government is loosening its purse strings. The Italian government is engaged in a major confrontation with the European Commission, which, however it ends, is likely to mean looser fiscal policies than originally intended. The Chinese government, concerned about the impact of the US-initiated trade war on its economy, is eyeing fiscal easing. And so on.

Meanwhile, after years of ultra-loose monetary policies, central banks are moving towards normalising (although not yet really tightening) their stance. This is taking two forms: higher interest rates, a process already begun in the United States, Canada and the United Kingdom, and likely on current trends to begin in the Euro Area next year; and ending and eventually reversing quantitative easing in countries where this took place, again, begun in the USA (reversal) and the UK and Sweden (ending) and coming to the EA (ending at least) in early 2019.

This shift in policy is getting added impetus from the fact that headline inflation in most major economies (and core inflation in some of them) is reaching its target. Even in Japan, inflation, 1.6% in the year to October, is at a 4 ½-year high.

On the face of it, therefore, the switch in policy mix seems justified. However, three issues give cause for concern:

First, broad money growth has recently slowed substantially in the largest economies. US broad money growth has halved, from more than 6% in mid-2017 to below 3% in late 2018 (this is detailed in our Commenton 9thNovember). Euro Area broad money growth has slowed less, but from above 5% to around 4.5%; in the UK, the slowdown is from 6-7% to barely above 5%; and in Japan from around 3.5% to around 2.5% over the same period. The most pronounced slowdown is in China, where M2 growth has been below 9% for eight of the last twelve months. This is the weakest performance since reliable Chinese monetary data began in 1986.

Second, other leading indicators, such as sentiment, housing market data and car sales are also showing signs of weakness, confirming the monetary message.

And third, and most worryingly, all experience – including, as noted above, the post-Great Recession era – shows that if monetary and fiscal policy are working in opposite direction, it is monetary policy that matters. Fiscal policy can reinforce monetary policy, but, on its own, tends to have minimal impact.

Hence, data is pointing towards a slowdown in global activity in 2019 – but the crucial policy Is generally moving in a pro-cyclical direction, which is likely to exacerbate that slowdown.

True, the Federal Reserve is likely to pause its interest rate increases in 2019. But elsewhere, monetary policy is either driven by a desire to normalise policy, or, as in China, constrained by the surge in debt over the recent past.

This cannot be good for asset prices. An end to austerity does not yet mean any major fiscal stimulus; and even if it did, that would, as noted above, most likely be fleeting and have minimal impact. By contrast, any withdrawal of liquidity – and that is what no more QE, the beginning of QT or simply slower broad money growth all boil down to – means that the monetary underpinning for asset prices over the past eight years will diminish and disappear.

It is difficult to know what markets should wish for. Slower output growth will mean continued subdued inflation and no need for higher interest rates – but weaker asset prices.

A much stronger fiscal stimulus could possibly boost activity in the short run and see markets rising. But that would also spur fears of inflation, causing central banks to step up their normalisation/tightening. If they do not, then bythis time next year they may find themselves having to play catch-up as inflationary pressures take hold.  And if there is one thing asset markets do not enjoy, it is the combination of rising inflation and rising interest rates from central banks deemed to be behind the curve.

Either way, the outlook is unappealing.

[1]World broad money is our own composite measure. It sums broad money in the United States, the Euro Area, Japan, Canada and the United Kingdom. There is also a measure including China, but this is for the purposes of this article less relevant due to the sharp difference on growth rates over the period. All measures are the average of monthly 12-month growth rates for the year.