1. Art and Diseño

ECONOMIC
UPDATE:
The Long Expansion
Richard B. Hoey
Chief Economist, BNY Mellon
The global economy remains in a long economic
expansion. Due to low inflation and the slow pace of
expansion, monetary policy has been able to retain
more of an early cycle stance than a late cycle
stance. For now, many central banks are motivated
to maintain an easy monetary policy, given the fall in
both actual inflation and expected inflation.
We expect global GDP growth to run somewhat
faster in 2015 and 2016 than it has in the last three
years for several reasons, including the avoidance of
special drags, much lower oil prices, and past and
current monetary ease. Several special factors
which held back growth in 2014 are unlikely to be
repeated. These include the weather-impacted
decline in U.S. GDP in the first quarter of 2014 and
the Japanese recession in the middle two quarters
of 2014 due to the rise in the value-added tax. A
second round of fiscal tightening in Japan, originally
planned for 2015, has now been postponed. We
expect low energy prices to help support global
growth. The benefits of the sharp decline in oil
prices for global growth should exceed the drag from
those sectors and countries negatively impacted.
We also expect that current and past monetary ease
will contribute to global growth.
In recent weeks there have been monetary policy
easing moves from the ECB, the Swiss National
Bank, the Bank of Canada, the National Bank of
Denmark, Norway’s Norges Bank, the Central Bank
of the Republic of Turkey, the Central Reserve Bank
of Peru, the Reserve Bank of India, and the Central
Bank of Egypt, among others. In addition, with
February 2, 2015
downward pressure on inflation, countries expected
to tighten monetary policy in 2015 should have
greater flexibility to limit or delay their monetary
tightening, if they wish.
Recent currency trends should support global
growth.
There should be a boost to export
competitiveness in such economically weak regions
as Europe and Japan, due to sharp declines in their
currencies. Because these currency declines have
coincided with a sharp drop in oil prices, the
currency declines are more likely to have cyclicallyappropriate anti-deflationary effects than to
generate excess inflation. One reason that other
countries have tolerated the currency depreciation
strategies of the ECB and the Bank of Japan is that
in both cases inflation is running well below the
central bank’s target. Therefore, these policies can
be viewed as appropriately anti-deflationary in an
inflation-targeting context.
The recovery in global growth has been more
sluggish in this cycle than in past recoveries.
Despite the aggressive use of credit to finance the
leveraged purchase of existing assets, the appetite
to use credit to finance increased current spending
has been restrained until now in many countries. In
addition, there has been a downward shift to lower
trend growth in China. China engineered a domestic
credit boom a half-decade ago to limit the spillover
to the Chinese economy of the global financial crisis
and global recession. However, the hangover from
that credit boom is now contributing to a slowdown
in the growth rate of China. This is occurring just as
there is a demographic inflection point to slower
growth in the Chinese labor force. We believe that
the outlook for the Chinese economy is a downward
shift to slower trend growth rather than a hard
landing.
An additional trend which has restrained the pace of
global growth (but not its longevity) is that the global
trade multiplier has dropped. In past cycles, global
trade tended to grow more rapidly than global GDP
(i.e., the global trade multiplier was above 1.0). As
emerging markets are now becoming more
dependent on domestic demand growth than in the
past, the global trade multiplier has shifted down,
with global trade and the global economy both
growing at about the same pace.
There has recently been a very sharp drop in
commodity prices. Both the old normal and the new
normal in the commodities market is an alternation
of cyclical booms and busts. In general, copper
mines and oil wells tend to be long-lived assets and
remain in production long after the boomtime
demand has ebbed. The current commodity bust
was created by three basic factors: (1) past
overbuilding of capacity due to cheap capital and
enthusiasm for an expected commodity supercycle
of emerging market demand led by the Chinese
goods producing sector, (2) a subsequent slowing in
emerging market demand growth, especially in the
Chinese goods producing sector and (3) a favorable
supply shock due to technological innovation,
notably in U.S. shale oil production.
When commodity prices decline sharply, it is
important to distinguish the causes. The source of
commodity price weakness has important
implications for the outlook for future global growth.
If commodity prices plunge because the global
economy goes into recession, the decline in
commodity prices is merely a symptom of bad
economic news. We do not believe that is what is
now occurring. It is true that there is some demand
weakness for commodities. We believe that is more
attributable to a downward shift in the trend growth
of the goods producing sector in China than to broad
global economic weakness. In addition, some of the
demand weakness is technological not cyclical. For
example, demand deceleration due to technological
innovation (such as cars with better mileage) should
not be regarded as a cyclical signal of a weak global
economy. We believe that the main story today is
not cyclical weakness in the demand for
commodities. Rather it is that there has been an
expansion of cheap supply due to overestimates of
commodities demand from China combined with
successful technological innovation, notably in
shale oil. Technological innovation in the oil and
gas sector is a positive supply shock.
We expect that weak energy prices will aid real
income growth and global economic expansion. It is
notable that in prior periods when there was a sharp
decline in oil prices without a U.S. recession, such
as 1986 and 1998, the resulting combination of low
inflation and improved real income growth
contributed to solid economic growth and a rise in
stock prices to very elevated levels, eventually
building towards stock market peaks in August 1987
and March 2000.
We expect low energy prices to persist long enough
to provide substantial support for a long global
expansion. In the long run, the relatively high full
cycle cost of newly developed energy supplies
implies that oil prices should eventually return to
higher levels. However, we expect that sharply
depressed crude oil prices are likely to persist for a
number of quarters. Few existing productive assets
will be shut in quickly, as the marginal cash costs of
continuing to produce are relatively low. The
depletion rates of shale oil are relatively fast, so
that a plunge in new capital spending should
eventually rebalance oil supply/demand over the
next several years.
However, rig productivity
continues to improve and capital spending dollars
should stretch further as rising excess capacity in
the oil service sector should lower costs
substantially. The adjustment in supply growth
should eventually occur, but only slowly. Overall,
we expect that low energy prices will make a
favorable contribution to a long global expansion for
the next several years.
Central bank policy rates today are already at or
somewhat below the “so-called” zero bound in
many developed countries. As a result, additional
monetary easing in response to below target
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ECONOMIC UPDATE — February 2, 2015
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inflation can be somewhat complex for some central
banks to engineer and complex for analysts to
evaluate. Quantitative easing has proved to be
powerful monetary medicine, but there is a risk that
dangerous side effects will emerge in the future.
Long-term sovereign bond yields have traditionally
been regarded as the anchor of valuation estimates
for other assets. To the degree that central bank
manipulation of long-term sovereign bond yields by
quantitative easing creates a “crooked ruler effect,”
there is a potential risk of asset bubbles.
Reduction of the normal sovereign bond supply
available to the private sector has been engineered
by each of the G4 central banks, either in the recent
past (Federal Reserve, Bank of England) or currently
(Bank of Japan, ECB). This may prove to be a
monetary oversteering, giving rise to the risk of
asset bubbles, followed by an eventual financial
hangover in some future year.
Expectations of inflation have been falling. We
believe that the markets are totally rational to lower
estimates of inflation over the next year or two.
However, we suspect that the sharp plunge in very
long-term inflation expectations as measured by
bond market breakevens may prove to be a mistake
in the end. Given the intensity of anti-deflationary
policies which have been adopted by the central
banks, higher inflation should return--just not soon.
We are quite skeptical about the concept that
central banks will prove unable to accelerate
inflation in the long run.
We believe that the ability of central banks to drive
inflation higher has been limited by bank
deleveraging (especially in Europe) and round after
round of financial regulatory tightening. We believe
that this has recently disrupted the transmission of
excess financial liquidity into credit-financed
current spending, but that pattern may not prove
permanent. We believe that restrictive financial
regulation has created a gap between gross
monetary policy (which is aggressively stimulative)
and net monetary policy (moderately stimulative).
While the central banks have jammed down the
monetary accelerator, the financial regulators have
jammed down the regulatory brake, resulting in a
grinding of gears in the financial system. Over the
coming years, however, we expect less incremental
regulatory tightening beyond what has already been
decided. If so, excess liquidity is likely to be
eventually mobilized to finance increased spending
in the real economy and generate a faster pace of
nominal GDP growth and inflation.
Most developed countries have inflation targets
near 2% over the medium term. This is due in part
to Janet Yellen’s success at the July 1996 FOMC
meeting in persuading Alan Greenspan of the
benefits of an inflation target near 2% rather than
zero. In many developed countries, core inflation is
currently running about 1% lower than a 2% pace,
certainly a less challenging problem than if core
inflation was running near minus 1%, roughly 1%
below a zero target. Our view is that the risks of a
major deflation are low, but with inflation below
target in many developed countries, global
monetary policy is likely to remain quite easy over
the next several years.
There are different kinds of deflation and lowflation,
with very different consequences. One of the worst
kinds of deflation is a collateral deflation which
reflects a sharp decline in collateral for bank loans,
threatening to create a financial crisis. That’s what
occurred in the Great Depression. Former Fed
Chairman Ben Bernanke was very aggressive in
combatting the collateral deflation risk in 2008 and
2009. Now that core banks have delevered their
balance sheets, asset prices have recovered and
tight financial regulation has suppressed risktaking by financial intermediaries, we believe that
the risk of collateral deflation today is low in the
context of easy monetary policy. Notably, much of
the energy-related risk has been taken on by
unlevered final investors outside the banking
system.
Much of the current concern among developed
country central banks about low inflation and falling
inflation expectations is linked to concern about
“monetary traction,” the ability of central banks to
arrange real yields (nominal yields minus actual or
expected inflation) low enough to stimulate
economic expansion. With short-term nominal
interest rates down near the so-called zero bound,
we believe that most major developed countries will
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ECONOMIC UPDATE — February 2, 2015
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be able to grow somewhat faster than their
relatively modest potential real GDP growth rates
over the next several years. While European and
Japanese inflation may fall short of the inflation
targets of the ECB and the Bank of Japan for several
years, our view is that deflation risk will fade. The
long global expansion we expect should gradually
calm fears of deflation.
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