What’s at Stake in 2015-16?

May 12, 2015

This summer will mark the eighth anniversary of the onset of the subprime mortgage loan crisis that spawned a deep world recession and Euroland’s debt crisis.  It’s taken this long to arrive at a point where policymakers are attempting to reverse the massive stimulus of the period.  Most notably, the Federal Reserve will soon begin raising the federal funds rate target.  Fresh with a new and strengthened political mandate, Britain’s Tory government plans to tighten fiscal policy.  In China, officials are hoping to provide just enough macroeconomic support to stop economic growth from decelerating further but no more than is necessary to achieve a 7% trend in GDP expansion.  The Bank of Japan will only augment quantitative easing further as a last resort even though inflation is back at zero.  A German-led faction at the European Central Bank believes that underlying inflation has already turned a corner, averting deflation, and it has become increasingly disposed to the idea that the remaining currency union will be better off without Greek membership than with such.

In the remainder of this year and next, the proposition that the world is ready for selective policy normalization.  At best, some economies have demonstrated an ability to function with the aid of enormous stimulus.  The most attention has been on the United States, where unemployment has fallen to 5.4% from a Great Recession high of 10.0%.  But the U.S. recovery mustn’t be overstated.  Real GDP climbed at similar rates of 2.3% in 2012, 2.2% in 2013, 2.4% in 2014 but just 1.2% over the latest two calendar quarters.  Growth is being maintained but not strengthened with virtually zero interest rates at the short end and historically low long-term yields, too.  This is broadly weaker than the U.S. performance between end-1995 and end-1996, when real GDP expanded at a 4.7% pace in spite of an average 10-year Treasury yield of 5.9%.  That was also a period of sustained multi-year dollar appreciation.  So the question looking ahead to the next 18 months or so is not so much what policymakers do or even how forcefully that change policy, but rather how do economies respond to the change.  Can the U.S. tolerate Fed normalization?  Can Britain handle another dose of fiscal restraint?  Where’s the bottom in China’s growth slowdown, and has the deceleration thus far merely been a preamble to a full-blown debt crisis?  Is 2% inflation with 2% growth even possible in Japan?  Will an engineered departure of Greece from the common European currency area produce catastrophic results and manageable ones?

Markets will play a big role in deciding such questions.  Exaggerated investor reactions can transform measured policy changes into transforming developments that force officials to abort their plans.  This happened in Japan in 2000 when the BOJ exited its zero interest rate policy, and the economy slipped into recession. 

The polarity in the current direction of Fed policy and the stances of the Bank of Japan and ECB had lifted the dollar sharply from May 2014 until earlier this year.  Some of the dollar’s gains have been given back.  Whether the dollar has run out of steam or is just catching its breath will be decided by how well the U.S. economy tolerates a Fed policy that’s in tightening mode.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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