It is likely the direction of change in forecasts for economic growth will continue to decline over the summer.
We are not expecting a recession. Rather, a muddle through scenario seems the most likely. But the cyclical backdrop in the world’s largest economy has deteriorated and this will have implications, particularly if the unemployment rate stops falling.
QE2 ends on June 30. There is much commentary suggesting that the end of QE2 is “no big deal” and given the Fed is not going straight to shrinking its balance sheet but will rather reinvest maturing mortgage debt to the tune of $30m per month, then there may be some justification to that characterisation.
However, QE2 was instigated to help the nascent economic recovery with a particular focus on the labour market. If the recent weakness continues, particularly in an important leading indicator of the labour market like initial jobless claims, then look for the chatter about “QE3” to pick up some momentum.
Accommodative
So much has been committed to boosting the financial system and the economy in recent years — $17 trillion is our estimate of what has been lent, spent or guaranteed by the US, EU and UK governments and central banks since 2007. No policymaker in the west is going to stand-by and allow a situation that threatens the banks and/or the economy without trying more stimulus to fight it.
The bottom-line is that policy will remain accommodative. That is, of course, unless something comes along that makes markets nervous that the consequences of all this accommodative policy will be inflation.
But there is no sign of this. One example is the level of those low nominal bond yields relative to local inflation rates. Since August 2010, the UK has been able to borrow money for 10-years at a negative real rate, as gilts have yielded less than the UK inflation rate (as measured by CPI). As we know, this is enormously helpful to a country that is trying to reduce the burden of its government deficit.
Recently the US has also been able to do this. A country allegedly on the precipice of a rating downgrade. With a currency that allegedly no-one wants. With a worse fiscal deficit than anyone else and a monetary policy for which Loperamide Hydrochloride (imodium) would seem the only cure. And yet it is also borrowing money for 10-years below its current inflation rate of 3.2%.
The conclusion is clear. Markets are not worried about western inflation.
Downside
This is, of course, not all good news. After all, one of the objectives of QE2 was to raise inflationary expectations. Yet the level of nominal bond yields relative to current inflation suggests that market inflation expectations are lower today than in early 2010 when QE1 ended.
This is surprising, given that commodity prices are higher today than in the spring of 2010. High prices for things that we buy regularly do affect inflationary expectations. After all, we all suspect inflation is higher than is reported when we are paying more, it seems, each time we buy a tank of petrol or go grocery shopping. But those inflationary expectations cannot be turned into demands for wage inflation when unemployment rates are high.
So higher inflationary expectations just result in the sort of dissatisfaction that leads to demonstrations on the streets on occasion and poor poll ratings for US Presidents, even after the Bin Laden event (Obama still has an Approval rating under 50%).
What this means is that there is unlikely to be follow-through from rising prices of commodities into wage inflation and, consequently, domestically driven inflation will remain muted. This in turn suggests that raising interest rates is not a wise move for western central bankers.It will just exacerbate the fragility of consumer confidence in the wake of ongoing housing market weakness, negative real wage growth and weak labour markets.
We therefore continue to be sceptical that either US or UK interest rates are going up in 2011.
