A roaring end to the summer
The summer was full of surprisingly good news on growth in advanced economies, and European economies in particular. The exception was the United Kingdom, in the grip of a political crisis faced with the first setbacks linked to Brexit, the decline in sterling and the resulting surge in inflation, amid a wait-and-see climate that is casting a shadow over the growth outlook. In the United States and the euro area, activity appears poised to deliver another year of above-potential growth. Unemployment is falling, and the United States and Germany are approaching full employment. The overall environment is favourable. The years of slow growth in the emerging world and of falling commodity prices appear to be behind us, as do the deflationary pressures that threatened to hamper global growth, which maintained a cruising speed of just over 3% in the second quarter and over the summer.
Europe has emerged from a tense electoral cycle that saw risk aversion peak in the spring. It has since become an anchor of stability, in spite of the growing uncertainty surrounding Brexit negotiations. In the United States, the question remains the same: could political vagaries get the better of a policy mix that up to now appeared coherent? The hopes placed by investors in Trump’s tax reform and continued cautious monetary normalisation appear to want to set aside this risk.
Positive surprises on growth could even cause economic agents, who in recent years have become accustomed to a gloomy climate and successive downgrades in economic forecasts, to reconfigure their adaptive expectations. Could this be enough to revive animal spirits and set in motion a new virtuous circle? Let us not get carried away! For the time being, it has been enough to shift the debate over the summer away from growth and towards monetary and currency issues. The rebalancing of global growth and convergence between regions have reduced the need to hold the dollar as a risk-free asset. And the euro is ‘benefiting’. Admittedly, this also reflects the improvement in activity in the euro area and the upturn in inflation, the decrease in political risk, and even hopes of progress in the construction of the economic and monetary union. It is also a result of the Fed’s hesitation over the timing of upcoming rate hikes. Consequently, the euro is up 13% against the dollar in the year to date, and up 5% against the main region’s trading partners. However, it is also a sign that markets have priced in the fact that monetary policy divergences between Europe and the United States are becoming less marked. The summer rally in German sovereign yields should be short-lived. Central banks will undoubtedly attempt to contain enthusiasm as they begin to downsize (Fed) or stabilise (ECB) their balance sheets. Peripheral risk premiums, which have compressed significantly since the French elections and the Italian government’s bail-in of Venetian banks, will begin to increase again as the Italian parliamentary elections approach in the first half of next year. However, we do not think central bank action will cause volatility to surge. Central banks in advanced economies are currently sitting on a monetary base of $15,000 billion, built up through quantitative easing. From atop this base, they observe the comforting panorama of growth. But they remain bothered by their inability to drive inflation up to its target level. As long as deflationary risk was present, the situation was, paradoxically, easier to manage: extreme times call for extreme measures. Today, above-potential growth is generating inflation, but not enough. In the meantime, asset prices are inflating, forcing central banks to pay more attention to risks linked to financial stability. But technical constraints are also making it more difficult for the ECB in particular to continue expanding its balance sheet. Central banks are therefore questioning their mandate and goals, and thinking about how to adapt their toolbox to a new situation: a cycle where inflationary pressures arise much more slowly than in the past. They are looking for explanations: the ageing population, the trend towards globalisation, technological innovation, structural labour market reform, a more regulated credit cycle, etc. Whatever the cause, this slower pace of growth in inflation means central banks need not sharply hike interest rates and can keep a large portion of public debt frozen on their balance sheets. And all of this is good for the economic cycle. They will just have to keep their cool when they are accused of being behind the yield curve to explain that this is because of the new way the global economy is operating. Their caution was evident at the annual summertime meeting of central bankers at Jackson Hole: no mention of their normalisation process, questions over how to speed up growth at a time of changing monetary policy, and a reminder of the extent of progress on regulation and the importance of maintaining free trade and exchange rate coordination. The ECB has given no indication of what it might announce at this week’s meeting. Euro appreciation is a cloud that could sully Mario Draghi’s apparent serenity when he gave his last speech before the summer: it could curb growth, but above all inflation, even if the currency becomes more expensive for good reason.
By Paola Monperrus-Veroni, Economic Research department