Can the Global Economy Handle Fed Tapering?

January 30, 2014

Being in unchartered waters, that’s a matter that remains to be answered in the months ahead.  Given the high level of uncertainty, it’s not surprising for the investment community to feel uneasy.  Sovereign debt markets shuddered at the first whiff of tapering plans late last spring, and emerging markets have been battered lately now that tapering is a reality rather than a prognosis.  The assertion by Fed officials is not universally accepted that their stimulus is a function of the cumulative level of quantitative asset purchases, not the incremental change in the pace of buying.  The argument would be true in this instance only if markets treat tapering as macroeconomically irrelevant, which hasn’t been the case.  And from a second-derivative standpoint, tapering represents a shift in the monetary stance.  On the arc from infinitely accommodative to infinitely restrictive, U.S. monetary policy will continue to lie on the far accommodative side of spectrum but has at last begun moving closer to the center and further from the extreme.  This is not the first such move.  The first and second rounds of quantitative easing each ended for a period of time

The Fed’s need to resume quantitative stimulus after those halted programs, and the much longer body of Japanese evidence with a central bank intent on normalizing monetary policy but finding an economy that couldn’t handle such weaning, had led me to wonder quite some time ago whether an extended opportunity would come that Fed policy could safely be tightened.  Seeing the disturbance to other world economies, I’ve lately expanded that concern to the question posed in this article’s title.

Even after 3.7% annualized U.S. GDP growth in the second half of 2013, one can still argue that the recovery looks sub-standard, if not fragile.  The past four calendar years show a saw-toothed pattern of GDP expansion that’s hardly accelerating: 2.5% in 2010, followed by 1.8% in 2011, 2.8% in 2012 and 1.9% last year.  GDP expanded merely 1.0% per annum over the last six years from the pre-Great Recession peak and by 1.7% a year during the decade between 4Q03 and 4Q13.  Because of the diminishing marginal utility of income, a very concentrated distribution of incremental growth in GDP and wealth can be expected to support a smaller future stream of spending than would a more widely shared prosperity.  Much, too, has been made of the faster-than-expected decline of the jobless rate, but other labor market indicators remain disturbing.  One of these is the historically high level of long-term unemployment.  Another is the gap of 31.6 million workers between the current 136.9 million level of jobs and the 168.5 million hypothetical level it would be at if jobs had merely grown after Y2K at the same pace they did during the two decades between end-1979 and end-1999.

Disinflation continues to be a stronger force than inflation.  The enormous continuing slack in U.S. productive resource usage was associated with a core personal consumption price deflator that went up only 0.7% annualized between 3Q13 and 4Q13 and 1.1% year-over-year, down from 1.7% in the year to 4Q12.  There’s also disinflation in the euro area and China.  Euroland inflation fell from 2.2% on year at end-2012 to 0.8% last month; core CPI dropped to 0.7% from 1.5% a year before.  On-year Chinese CPI inflation of 2.5% in December was the lowest since June.  Chinese GDP grew 7.7% in 2013, down from 9.2% in 2011 and 10.4% in 2010.  This nearly 3 percentage point decline in growth since 2010 is like going from 3.0% to no growth at all or a slowdown from 4% to 1%.  China and the euro area represent roughly 30% of global GDP, nearly 10 percentage points more than the U.S. share.

To the detriment of emerging markets, Fed tapering — as reduced quantitative stimulus is euphemistically called — is having a significant effect on the directionality of global capital flows.  Over the past year, the Argentine peso has depreciated nearly 40% against the dollar, the Turkish lira, Indonesian rupiah and South African rand have each lost a bit more than 20%, and the declines of the Brazilian real and Indian rupee are above 10%.  Central banks in these economies have been pressed into raising interest rates that will weigh on economic growth.  And as good as anyone’s economic growth has been, including the United States, bear in mind that everything seen was achieved with abnormally low interest rates.  Any scent of less accommodative monetary stances could produce a greater smothering effect on future growth than the models that guide policymakers suggest.

Among the major dollar relationships, dollar/yen has drawn heightened attention because the yen is seen as a barometer of risk on/risk off psychology.  As the euro area financial strains lessened in 2013, equities rose, and the yen fell.  From a low of 105.44 per dollar on January 2, 2014, the yen recovered 3.4% to 101.82 yesterday.  However, that constituted less than a 12% reversal of the prior slide from 77.44 in late September 2012.  Moreover, the yen at this writing remains reasonably close to its year-to-date average of 103.9/USD. 

At $1.3550, the euro is too expensive for an economy that continues to underperform alarmingly.  According to the recently updated Big Mac index that examines currency under- or over-valuation through the lens of purchasing power parity theory, EUR/USD is almost perfectly aligned.  But for a region that desperately needs to find an external source of aggregate demand, the euro needs a big depreciation that to date remains forecast but not reality.  EUR/USD has slid only two cents below its end-2012 level and remains some 11% stronger than its lifetime mean.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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