Weekly Economic Commentary
July 12, 2013
of Northern Trust
- The view of Spain’s economy from the ground is no prettier than it is from distance
- Not all forward guidance is created equal
- China’s suspension of key economic data raises, not quells, concern
My family just returned from a trip to Northern Spain, where my son’s soccer club played in a tournament. Given the setting, the balance between austerity and growth was a topic of daily conversation. Not the economic version of that tradeoff, mind you, but its application to the nocturnal doings of the boys. Should these soon-to-be-collegians be allowed to indulge expanded freedoms in thecalles y tabernas, and grow from the experiences (good or bad)? Or should some modicum of austerity be required to limit potential future consequences? These were the questions facing the chaperones among the traveling party.
While I try not to think about business while away, I could not help contemplating the financial version of the growth versus austerity debate. Signs of stress were everywhere we went. It’s a pity that such a beautiful part of the world has fallen into such an ugly economic situation.
At one tournament venue, nestled in a gorgeous river valley, rows and rows of empty condos sat next to an undeveloped lot that was being used for growing food. The scale of farming operations suggested that this was not simply a summer diversion. Scores of apparently unemployed adults populated the local bar at mid-afternoon. Conversations with those locals who could manage some English and indulge my fractured Spanish reflected a mixture of despair and disgust.
Over the past couple of months, investor despair and disgust over Spain and other peripheral countries has risen amid continuing economic malaise.
Recent actions and statements from the European Central Bank (ECB) have been seen as reducing the risk of a worst-case outcome, but have as yet been unsuccessful at turning the tide of negative news. Countries have been given a little more time to meet debt reduction targets, but this leaves little room for actual stimulus. One senses that the best case for portions of Europe is an extended period of very modest economic progress.
There is a deeply rooted anger at government, at both the local level and within the European Union. Given the scale and scope of economic misery, it is fortunate that Europe hasn’t had more active uprisings. There is certainly precedent for such things in European history.
Since we found ourselves in Catalonia and Euskara (Basque Country), the wish for independence from greater Spain was only thinly concealed. And some residents certainly wondered whether they might be better off outside of the eurozone. As these suggestions coincided with the American Independence Day celebration, it made me wonder: what are the pros and cons of associations among provinces, or nations? When, indeed, in the course of human events does it become necessary (or desirable) for one people to dissolve the political bands that have connected them with another?
Unfortunately, the common bands of debt in Europe today make disentanglement a difficult proposition. It is certainly not clear that states would be better off separately, since collective fiscal circumstances and monetary institutions are stronger than local analogs would be. Abrogating debt might be satisfying in the short-term, but might also serve as a prelude to financial equivalent of nuclear winter.
Perhaps we are expecting too much of Europe at the moment. Given its structural challenges, we cannot ask for economic growth that matches that of other regions. Europe will need time and lots of political will to sort things out to everyone’s satisfaction.
We certainly did our bit to stimulate the local economy, pouring euros into local commerce at an active rate during our stay. Fortunately, none of this came in the form of bail money for ourjugadors.
Forward Guidance – One Size Does Not Fit All
The use of “forward guidance” by the world’s central banks is advancing as a monetary policy tool. But not all forms of forward guidance are the same, and the success of these programs may vary over time and place. Forward guidance is simply an expression of a central bank’s future intentions. Promising to keep short-term interest rates low, for example, can bring down longer-term interest rates and help economic sectors sensitive to them.
Precedents for forward guidance go back to 1997. Its first application in a major market occurred in 2003, when the Greenspan Fed specified that “policy accommodation can be maintained for a considerable period.” But a turning point in the use of forward guidance occurred after the financial crisis, when the Fed had to devise new tools as the policy rate reached zero in December 2008.
At that juncture, the Fed could not lower the policy rate any further, but hoped to do more to support economic activity. The Fed’s promise to keep the exceptionally low federal funds rate unchanged for an extended period served the purpose of containing long-term yields, which brought mortgage rates lower.
Forward guidance of this sort is useful, but leaves markets uncertain about the duration of a low policy rate. To respond, vague forward guidance changed to calendar-based guidance in 2011, with the Fed indicating it would hold the federal funds rate steady until mid-2013. This was intended to clarify the duration of easy policy, but the timing was modified twice the next year. (The promise ultimately extended to mid-2015.) This pattern did not add clarity for investors; given updated assessments of the economy, it is always difficult for a central bank to stick to a specific date.
And so the Fed moved to a state-contingent version of forward guidance in December 2012 when it identified precise thresholds (6.5% unemployment rate and 2.0% long-term inflation) for considering an increase in overnight interest rates. It took another six months before it clarified the conditions under which it would terminate the current asset purchase plan (7.0% unemployment rate, with solid job growth supporting further job gains).
The distinct advantage of this version of forward guidance is that the central bank is not locked into acting on a certain date, but has the flexibility to take steps as economic conditions change.
The evolution of forward guidance from the Fed's vantage point reveals its different flavors and offers lessons for the Bank of England (BoE) and the ECB. But differences in the mandates of the institutions and the markets they serve will have an important influence on the design of forward guidance in Europe.
At its July meeting, the ECB stated that rates could stay at record lows for an “extended period,” and could also fall further. The BoE borrowed from the same playbook with its announcement that the recent “implied rise in the future path of the Bank Rate was not warranted,” and will soon publish in August a detailed study of how forward guidance could work in the United Kingdom.
The structure of these economies is not identical to that of the United States. In the eurozone, the size of the bond market is significantly smaller than the United States and the home mortgage institutional framework is different. Furthermore, the easing of monetary policy has not translated into a uniform impact on long rates among eurozone members, with the rates in the periphery noticeably higher than in Germany (see chart). Of late, Spanish bond yields have failed to follow the rally in the German bund market.
More importantly, as discussed in ourJune 21 commentary, credit is primarily extended through the banking system in the eurozone, and it is not clear whether forward guidance from the ECB will open that channel. Given the banking sector stress and disparity of economic conditions in the region, it is not clear that forward guidance will have maximal effect in the eurozone.
There are nascent signs of improving conditions in the U.K. economy. But a host of worrisome issues – a large current account deficit despite a depreciation of its currency, a stagnant economy with an elevated jobless rate, and a debt-to-GDP ratio that continues to advance – remain in place despite the asset purchase program and Funding for Lending Scheme. Under these circumstances, a state-contingent forward guidance is suitable for the United Kingdom as it is at a different stage of economic crisis compared with the eurozone.
And here in the United States we are seeing what the other side of the mountain for forward guidance looks like. The Fed has been trying to preview the timing of asset purchase tapering carefully, but has been greeted in its efforts with a lot of skepticism. It may well be that forward guidance works well in one direction, but not the other.
Despite all of its limitations, forward guidance is the new hot tool of global monetary policy. Time will tell whether it delivers on the grand expectations associated with it.
China: Data Transparency Is Not a Strong Point
China's recent decision to suspend the release of industry detail on its Purchasing Managers Index (PMI) was marketed by Chinese authorities as a needed step to ensure data quality. Instead, it added to growing concern that China's economic growth is quite a bit slower than expected.
PMIs are used worldwide as leading indicators of factory activity. (Some countries also have service sector PMIs.) They are based on surveys of businesses, not hard counts of production. A reading above 50 typically suggests expansion; below 50, decline.
China's "official" PMI has been descending toward 50 for some time now. (A private-sector survey conducted by HSBC has been below 50 for several months.) Slow export demand from Europe, in particular, has hindered prospects for the Chinese factory sector, which remains the country's engine of growth.
The official reason behind the reduced detail in the Chinese PMI report was that it takes a bit more time to carefully analyze the incoming data. But this series has been in production for some time, so the needed logistics are not new. Further, the decision not to report readings on exports and inventories struck skeptics as editing out information that was unpleasant. This suspicion only rose with the news that Chinese exports have actually declined over the last year.
Chinese officials likely hoped to staunch the tide of market negativism by depriving bears of data that would confirm economic slowing. But in doing so, they left the market to make its own assumptions about the missing information, which might certainly be worse than the truth.
The Chinese economy is going through a delicate transition, especially as officials try to curb excess leverage in the banking system. Our view is that the decision to cease publication of some key factory data hurts efforts to engineer a soft landing. As of this writing, the Shanghai equity index is down almost 20% from the start of this year; the PMI affair will not help to restore investor confidence.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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