Macro View: Central banks are running out of ammunition

EQUITY prices have touched recently new highs in the US and Europe, but the mood of the financial markets remains cautious and apprehensive. On the positive side, global fears over the UK’s Brexit vote have eased. In spite of worries that the UK economy is slowing, growth in other major economies is mostly unaffected by Brexit. Even in the UK, the current gloomy mood is unjustified.

The main change so far has been a sharp fall in the value of sterling against all major currencies. But, though a weaker currency has drawbacks, it can also help the economy at a time when significant adjustments will have to be made, particularly if Brexit produces major changes in the structure of UK trade flows. The main global concerns are unrelated to Brexit. In spite of the markets’ buoyancy, the foremost anxieties are due to widespread perceptions that the central banks are running out of ammunition, and are no longer able to support their respective economies with the tools currently at their disposal.

Ineffective tools

In recent decades central banks have played a pivotal role in economic policy. Since 2008, the role of monetary policy has become particularly crucial, because ballooning public sector debt and deficits made it very difficult for governments to use discretionary fiscal measures in any effort to boost economic activity. However, the main monetary tools are proving increasingly ineffective.

Indeed, some of the more extreme techniques, e.g. negative interest rates, are potentially counter productive. Since negative interest rates weaken banks, they risk more than offsetting any stimulus resulting from monetary easing, and the net effect on growth could be negative. Even if interest rates remain in positive territory, there is growing evidence that at levels near to zero, cutting rates and increasing QE will have at best negligible effects on economic activity. If it becomes clear that central banks are becoming almost impotent, the markets’ unease will worsen, and will heighten risks of sizeable stock market corrections.

The longer term implications of this situation are unpleasant and potentially ominous. Markets and Governments may have to accept that pessimistic scenarios such as secular stagnation are now the “new normal”. If true, the unpalatable implication is that we may be facing prolonged periods of low growth, which could threaten living standards over time. In the near term, such a gloomy view will be resisted.

The likelihood is that the central banks will intensify further their strategy of monetary easing, even though there must be serious doubts if doing more of the same will succeed. The Bank of England has announced a new major expansionary package in recent weeks, and the markets expect both the European Central Bank and the Bank of Japan to take further stimulatory measures in the next few months. Even in the US, where the Fed has signalled the possibility of considering modest tightening, policy makers are unsure over how to proceed, and are unlikely to take any new initiative in the near future.

Apocalypse not yet

Since the 23 June referendum there has been considerable pessimism over UK prospects, and many commentators have expressed widespread concerns that the Brexit vote would push the economy into recession. Even during the campaign, many thought that the slowdown in activity has started in the second quarter, as those supporting “leave” appeared to gain ground. So far, these fears have proved exaggerated, and have not been supported by the facts. Official figures show that, far from losing ground, UK GDP growth actually accelerated in the April-June quarter.

More surprisingly, post-vote data for July has been much stronger than expected, with surging retail sales, which increased by 1.5% compared with June. UK consumer confidence remained strong after the referendum. Although purchasing managers (PMI) surveys point to weaker business confidence, the unexpected July fall in the number of those claiming unemployment benefits shows that the UK labour market remained strong after the Brexit vote. The resilient July retail sales reinforce hopes that buoyant consumer spending and improving exports would offset any negative effects of the Brexit vote on UK growth.

Though UK GDP growth could slow to 0.8% in 2017, a recession is on balance unlikely. However, the Bank of England’s MPC reacted forcefully to fears of decline, by announcing early in August a multi-pronged package. This entailed a cut in Bank Rate to a new low of 0.25%, relaunching and expanding the QE (asset-purchase) programme, and providing cheap funds to the commercial banks in order to encourage lending. But the more recent positive figures suggest that the MPC has acted prematurely and may have “jumped the gun”. The decision to pre-empt risks by using a “sledgehammer to crack a nut” is understandable.

But, if the MPC inadvertently reinforced the impression that the economic situation is worse than it really is, it risks damaging confidence and worsening threats to growth. It now seems likely that the MPC would cut rates further before the end of the year. But there is a strong case of waiting until we have better evidence about the true state of the economy. Cutting rates and adding to QE unnecessarily is potentially harmful and should be avoided.

Eurozone decelerates

Eurozone GDP growth slowed markedly in the second quarter of 2016, to 0.3 per cent, down from 0.6 per cent growth in the first quarter. Official figures show that the eurozone economy was decelerating even before Britain’s vote to leave the EU in late June. Regional confidence was also hit by a number of terror attacks in July. Germany’s GDP expanded by 0.4 the second quarter, but France and Italy didn’t grow at all, and the overall picture was dismal. At its 21 July meeting, the European Central Bank kept policy on hold, and expressed confidence that the eurozone’s modest recovery would continue in spite of the UK’s Brexit vote. But the full minutes of the meeting, published in August, revealed deeper concerns over the outlook. There are acute worries that the poor health of many banks could still derail the region’s recovery. Although eurozone inflation rose to 0.2% in July, and GDP growth prospects are adequate (at 1.5% in 2016 & 1.2% in 2017) there is a realistic chance that the European Central Bank will take additional measures in the next few months.

The US economy remains the “star performer” among the developed economies. Although by historical standards the record is mediocre, the labour market showed renewed robustness in recent months. After a weak patch in May, the US economy created 292,000 jobs in June and 255,000 jobs in July, while the unemployment rate remained steady at 4.9%. There are still many challenges: US GDP is forecast to grow only 1.6% in 2016, with weak business investment. But the US economic data is sufficiently strong to keep alive the option of a rise in official rates before the end of 2016. Recently published minutes of the Fed’s July meeting, and comments by senior officials, show that policymakers are split about the timing of the next move. A September move cannot be ruled out; but given the uncertainties the Fed will probably be reluctant to tighten before the US November elections. On balance, it seems more likely that the Fed will only raise interest rates at its December 2016 meeting.

David Kern of Kern Consulting was Chief Economist at the British Chambers of Commerce between 2002 and 2016. He was Group Chief Economist at NatWest between 1983 and 2000.