These are puzzling times. Seven years after the financial crisis brought world output to a standstill, economists can't agree on why the recovery is still so meager, let alone what to do about it.
The International Monetary Fund in October cut its global growth forecast and began its semiannual report on the economic outlook with a simple lament: “A return to robust and synchronized global expansion remains elusive.” The IMF estimates that global gross domestic product expanded 3.1 percent in 2015. That’s the worst performance since the Great Recession in 2009, and the trend is the wrong way. The fund’s economists were predicting 3.8 percent growth for 2015 when outlook stories were being written a year ago. Now, they see 3.6 percent growth in 2016, and that’s down from a July forecast of 3.8 percent. Economists surveyed by Bloomberg expect the global economy to expand just 3.4 percent in the coming year. Elusive indeed.
So, as 2016 arrives, investors face a world where the tectonic plates of the economy are shifting. Central bankers in the U.S. and Europe are now opposing forces. The U.S. Federal Reserve intends to gradually withdraw monetary support, while the European Central Bank is keeping the taps wide open, and Japan and China are easing too. The Fed’s much-anticipated move to raise rates is supposed to be a sign of an economy that’s lifting off, but few people are cheering. Whatever measures the power brokers try to get the world economy out of its funk, they seem to yield diminishing returns.
The global policy debate is messy, but for the sake of argument, let’s say there are two dominant views. The first is more orthodox and says the world is just in a long post-debt-crisis hangover complicated by cyclical developments in commodities markets. A little more monetary stimulus, a bit of time to fend off deflation, and it’ll be fine.
The second, darker scenario posits that we’re entering a fundamentally different place in the world economy—where inflation and unemployment no longer behave the way they used to, where an aging population creates a permanent downer for output, where the more than $7 trillion that developed-market central banks have spent on quantitative easing has failed to banish deflation fears.
“It is difficult to find inflationary pressures anywhere, which is uncharacteristic of a recovery that has been in place for about seven years,” says Bob Michele, New York–based chief investment officer at J.P. Morgan Asset Management. “That tells us that something is different this time.”
For those who remember when an economist reporting no evidence of inflation was good news, a quick review of recent deflationary concerns is in order. Consumer price increases in the euro zone have been near zero or negative for the past year, and disinflation—a decline in the inflation rate—has been the norm in the region for the past four years. In the U.S., Fed Chair Janet Yellen asserts that inflation is on a path to reach her target of 2 percent, but not everyone is convinced. The IMF’s inflation forecasts for 2016 are around 1 percent or less for the euro area, Japan, and the U.S. This all counts as evidence that central bank stimulus isn’t working as planned.
Commodities prices, the culprit for much of the recent weakness in headline inflation rates, aren’t likely to lend much help in the coming year. A Bloomberg survey of analysts suggests benchmark U.S. crude oil prices will average about $55 a barrel in 2016, within a few dollars of the 2015 average. China’s economy, which helped push metals and energy prices to all-time highs when it was booming a few years ago, is showing strain as the government tries to shift from export-dependent growth to consumer-led activity. The 6.9 percent expansion China reported in the third quarter was the weakest since the global recession, and the full year likely will be the slowest pace in two decades.
Having trained in a world where central banks knew how to tame too-high inflation, as long as they had the independence to do so, monetary policy practitioners and academic economists are struggling today with the reality that price gains are absent.
There is “disarray” within the profession, says David Folkerts-Landau, chief economist at Deutsche Bank. Nonetheless, investors will have to grapple with the cleft in trans-Atlantic monetary policy, he says. A key point, according to Folkerts-Landau, is the likelihood that the euro will continue to lose value against the dollar. “We will most likely revisit this year’s lows of $1.05, and, who knows, we could even go lower and approach or break through parity.” The euro was worth about $1.07 on Nov. 10 and hasn’t been below $1.00 since 2002.
Analysts surveyed by Bloomberg expect the divergence in bond yields between the U.S. and Europe to widen in 2016, an inevitable consequence of better economic performance, and therefore higher policy rates, in Fed territory. Two-year U.S. Treasuries may yield 1.68 percent by the end of the year, according to the average forecast, compared with -0.12 percent for comparable German bonds.
Some $3.5 trillion of the roughly $25 trillion in government debt represented in the Bloomberg Global Developed Sovereign Bond Index currently has negative yields, underlining the strangeness that market professionals confront. In Europe, it’s impossible to find a period in the past 500 years when yields have been lower—and, yes, Deutsche Bank did look that far back in sovereign debt records.
With benchmark central bank rates close to or at zero and market interest rates often below it, 2016 could be the year when it becomes clear the standard arsenal of monetary policy instruments has been exhausted. In January, the ECB will still have at least €500 billion left to spend in its quantitative easing program, but there’s increasing skepticism this remedy will be effective.
“It’s hard to think that because it worked well in the United States, it will work well here,” Harvard University economist Martin Feldstein told a roomful of academics and students at Goethe University in Frankfurt in October. “I don’t see the mechanism of action that would actually cause either an increase in inflation or equity prices.”
If desperate times call for desperate measures, the increasingly strange ideas discussed in monetary policy circles signal these are indeed strange economic times.
Andy Haldane, chief economist at the Bank of England, has emerged as the leader among those contemplating how a changed global economy might require discussion and research on new policy prescriptions—even some that seem outlandish. “If global real interest rates are persistently lower, central banks may then need to think imaginatively,” Haldane said in a landmark speech in September. “These are the most fundamental challenges to face central banking in a generation.”
What bears examination? It’s at least “thinkable” that a central bank could shift its inflation target higher, he said. This would keep monetary policy supporting a recovery for longer and provide more room for benchmark rates to fluctuate above zero. “Simulations suggest a 4 percent inflation target gives sufficient monetary policy space to cushion all but the largest recessions historically,” he said. The cost to an institution in terms of its credibility and public support would have to be weighed, he said.
Another idea that’s within the realm of possibility and deserves research, according to Haldane, would be to replace paper currency with an electronic version so that negative interest can be charged more readily. Odd as this sounds, it might be a way to address a problem: Eventually, when banks pay negative interest, actually taking some of the money they hold, depositors have an incentive to simply withdraw their money and hold it as cash, which is why monetary policy runs out of room when rates drop to zero. The Bank of England is doing research on this idea, Haldane said.
Haldane isn’t recommending prescriptions like these—yet. He’s saying they should be studied and perhaps readied. They might belong in the monetary arsenal if current quantitative easing programs like the ECB’s don’t find traction in 2016. If the economy stumbles in the U.S., where the Fed may be starting its tightening closer to the end of a growth cycle than the beginning, a higher inflation target could get serious thought.
Rewriting central bank mandates or outlawing cash start to seem like reasonable ideas if the current low-growth, low-inflation scenario looks like it’s becoming permanent, says Mark Zandi, chief economist at Moody’s Analytics in New York. But, he argues that the explanation for the current malaise might be more straightforward than Haldane and others suggest—and that the appropriate remedy might be to stay the course. “I actually think monetary and fiscal policy has worked pretty well; it’s just that the shock we’ve had was so massive,” he says.
Even if they stop short of the ideas Haldane has raised, a growing number of economists want policy makers to pay more attention to how monetary and fiscal efforts interact. In Europe, monetary support for the economy has mostly played out against a backdrop of fiscal austerity, and even in the U.S., fiscal stimulus efforts wound down fast after the recession ended. Janet Henry, global chief economist at HSBC Bank, says this is a topic that should be on the agenda. But she’s skeptical that Europe will embrace anything that tightens the ties between politicians and central bankers. “So many still slavishly believe that we need totally independent central banks,” she says.
Erik Nielsen, London-based chief economist for Italy’s UniCredit, also wants a debate over how to better coordinate monetary and fiscal support for the economy. “I’d be delighted if the political class started to have a serious discussion about the policy mix,” he says. In his view, it’s a way to avoid putting the more oddball ideas in play. “You can either go down the road of a more plausible discussion on coordinating monetary and fiscal policy, or you can go into voodoo-land.”