This is an edited version of keynote remarks made by S&P Global’s chief economist Paul Sheard at the 15th annual Breakfast With The Economists panels, held in Auckland, Sydney, and Melbourne recently.
Baseline outlook for moderate growth
We look for real GDP in the US to be 2.1% this year and 2.3% in 2018, in line with the average growth rate since the US economic recovery started in mid-2009. There remains some slack in the labour market, monetary policy looks likely to remain quite accommodative, and the pro-business stance of the Trump administration appears to be buoying animal spirits.
What is now very aggressive monetary policy has been supporting euro-area growth, and we expect it to continue to do so.
Japan’s economic growth has picked up and surprised many on the upside recently. The Bank of Japan is maintaining a very aggressive monetary policy stance, and the fiscal headwinds have eased.
China’s growth has also surprised on the upside, as policymakers seem to have tilted the balance of policy toward attempting to keep growth strong ahead of the National Congress of the Communist Party of China in October. We expect real GDP growth of 6.8% this year, but growth next year to dip to 6.5% as the balance tilts more toward accelerating reforms.
India, on a purchasing power parity basis (and helped by a huge population), is now the third-largest economy in the world (albeit way behind China and the US), having seemingly cracked the code of economic development.
With the demonetisation shock of November 2016 now having been absorbed and the Modi government reforms providing some tailwinds over time, we look for real GDP growth of 7.0% this year and 7.8% next year.
With Brazil and Argentina finally emerging from their multi-year recessions, we forecast real GDP growth in Latin America of 1.4% this year, rising to 2.3% next year. In Australia, we expect real GDP growth to continue as the economy continues to rebalance after its China-induced mining boom of recent years. All in all, it is a fairly benign growth and policy outlook in the base case.
The shadow cast by the global financial crisis and great recession continues to fade; output gaps in the affected economies continue to close, and labour markets are getting closer to full employment; inflation remains low and incipient inflationary pressures are conspicuous by their absence, allowing developed world central banks to maintain varying degrees of accommodative monetary policies.
If this is the base case, what are some of the important things to watch out for? This is far from an exhaustive list, but let me focus on five.
Can the Trump administration find its feet?
The election of Donald Trump as president of the US shocked the world. By any measure, Trump is an unlikely and unusual president and drama, controversy and division have marked the first eight months of his presidency.
Overall the view is that the president has been quite ineffective thus far: signature reforms such as health care and tax reform and a trillion-dollar infrastructure plan remain stalled or slow in getting out of the gates.
But it may be too simplistic to extrapolate from the first eight or nine months of the Trump administration and write off the chances of the administration “getting anything done”. Instead, market participants and interested observers should watch out for signs that the administration is starting to find its feet and noteworthy policy achievements may start to come.
There are three reasons for this. First, in any new administration there is an organisational learning curve to go up and there is plenty of reason to believe this has been particularly steep and extended for the Trump administration.
Second, the recent personnel changes in the White House, head-spinning as they have been, speak to the president starting to impose some order and structure on the business of government. The appointment of John Kelly as the new chief of staff is particularly noteworthy. Kelly, a Marine Corps four-star general with considerable Washington experience, presumably has a mandate from Trump to make the White House and the administration run better.
Third, the clock is ticking to the midterm congressional elections in November 2018. It is common for a party that has gained control of the White House and both houses of Congress to lose control of one or both houses of Congress at the next election. Thus, there are serious political incentives for the Republican administration and the Republican-controlled Congress to demonstrate to the electorate that they “can govern” and to get some policy runs on the board.
The first litmus test of this supposition was how the president handled the looming threat of a government shutdown and the need to raise the debt ceiling in September.
The president surprised many by brokering a deal with the Democratic and Republican Congressional leadership ahead of this deadline to extend funding for the government to December 2017, and to suspend the debt ceiling until that date. This suggests that administration is settling down, auguring better for some policy headway over the coming months.
What kind of stamp will President Trump put on the Fed?
President Trump has a unique opportunity to influence the make-up and policy direction of the Federal Reserve. Janet Yellen’s four-year term as chair of the Federal Reserve expires next February and vice chair Stanley Fischer, whose term was to end next June, announced that he would be stepping down this year.
Trump has already filled one position, that of vice chair in charge of bank oversight. Randall Quarles is generally regarded as a market-friendly safe pair of hands. Two out of the other four governor positions are vacant. This means that come February next year, Trump could have nominated five out of the seven members of the Board of Governors of the Federal Reserve System, including the chair and two vice chairs.
When thinking about how Trump’s appointments could influence or reshape the Fed, broadly speaking, there are three main scenarios.
The first would largely respect the status quo. Trump could follow the convention of appointing notable academics or at least PhD economists to leadership positions. These would be seen in the policy and financial world as “strong” and as respecting the independence of the Fed.
A second possibility would be for the president to make appointments that are seen as “politicising” the Fed and compromising its independence and monetary policymaking integrity.
A third possibility would be for the president to use the appointments to change the way the Fed operates, but in a potentially good way. The president seems to have high aspirations when it comes to increasing employment. The Fed, on the other hand, seems to have its sights set lower, appearing to take the view that the economy is already quite close to full employment.
At the very least, one would expect President Trump to appoint members of the Board of Governors whose bias is to err on the side of “running the economy hot”, to see whether that “heat” leads to inflation starting to pick up or employment picking up. There is an even broader frame of reference. I would argue that one of the key learning’s from the financial crisis and its aftermath and from
Japan’s earlier deflationary experience is that the pendulum swung too far toward the independent, technocratic central bank having prime responsibility for managing the macroeconomy.
It is high time to rethink the existing macroeconomic policy framework and make adjustments where it makes sense.
Three lessons stand out: First, both fiscal and monetary policy have a role to play in managing aggregate demand and ensuring full employment, price stability, and financial stability; second, there should be more cooperation and coordination between monetary policy and fiscal policy: and third, not just fiscal policy but also monetary policy has redistribution impacts, and these need to be taken into account.
These lessons argue for the macroeconomic policy framework to be evolved in such a way that fiscal and monetary policy are seen as two complementary means for managing aggregate demand and can be coordinated in such a way as to produce the best societal outcome.
It is unlikely that President Trump has this scenario in mind. But judiciously moving the Federal Reserve in this direction via the appointments the president makes might be surprisingly consistent with his aspirations to “make America great again,” particularly when it comes to increasing employment.
Will 2018 be the year when European Union integration gains momentum?
There has been a sense for a while now that 2017 was a critical year politically for Europe because of the French and German elections. The financial crisis and recession it triggered exposed serious flaws in the economic and political architecture of the European Union; and the refugee crisis of 2015 exposed similar flaws in the way the external border is conceived and managed.
The lesson that was learned at the European political and policy level was that the EU was a “work-in-progress”, a metaphorical half-built house, and that the foundations of that house needed to be strengthened and the rest of the house to be built.
Thus, a European Stability Mechanism was established; the Stability and Growth Pact was strengthened; the ECB introduced its Outright Monetary Transactions programme; key pillars of a Banking Union were established; and in September 2016 Frontex was beefed up to become a new European Border and Coast Guard Agency.
At the same time, high-level political discussions, centred at the European Commission and the European Council, recognised that for the euro area to become a “genuine” economic and monetary union further moves toward fiscal, economic, and political union would be needed.
Will President Xi Jinping accelerate reforms after the Party Congress?
There is a similar theme with respect to China, albeit in a very different context. The National Congress of the Communist Party of China is held every five years and is closely watched because of the leadership changes that are rubber stamped at the Congress.
The 19th Party Congress, which opened in Beijing on October 18, marks the end of President Xi Jinping’s first five-year term.
In its latest statement, the BOJ notes that it expects its holdings of JGBs to continue to increase by around ¥80 trillion per year, which it has done since September 2016. As a result of its three variants of QQE since April 2013, the BOJ now owns about 42% of outstanding JGBs (and financing bills).
Taken at face value, the “overshoot” commitment in QQE with YCC has a surprising implication. The JGB purchases by the BOJ are tantamount to a debt refinancing operation of the consolidated government, whereby the central bank, rather than the Treasury, retires long-term government debt securities and refinances them into central bank money (reserves).
Assume that the BOJ sticks to this commitment and logically one of two things should end up happening:
One is that at some point the BOJ will succeed in achieving 2% inflation, in which case it will presumably stop buying JGBs.
A second logical possibility is that no amount of JGB purchases by the BOJ will succeed in achieving 2% inflation; in that case, if it stuck to its guns, the BOJ would end up refinancing the total stock of JGBs in existence into central bank money and could finance any ongoing annual budget deficits by creating central bank money. There would be no government debt securities in the hands of the public, only bank deposits that have central bank reserves as their asset backing.
It would seem that the BOJ, with the government’s support, wittingly or unwittingly has set up a scheme that renders moot one of Japan’s two big macroeconomic challenges: its chronic deflation and its mounting government debt.
Despite this aggressive monetary policy stance, inflation shows little signs of picking up any time soon. CPI excluding fresh food and energy was just 0.2% year on year. While there has been an improvement in the trend, it remains the case that inflation has been doggedly resistant to aggressive monetary easing.
Could this be about to change, though? All the talk in Japan these days is of a tight labour market and labour shortages. The unemployment rate is 2.8%, its lowest level since November 1993. Meanwhile, real GDP growth above the potential growth rate looks set to continue, suggesting that the labor market is set to tighten further – a trend that stands to be amplified by the aging of the population.
All eyes will be on who will replace Governor Kuroda when his five-year term expires on April 8 2018, or whether, bucking well-established convention, he is offered a second term or at the least the first part of one.
The resounding victory of Prime Minister Shinzo Abe in the House of Representatives election in October could support the public expectation that the future course of monetary policy will remain unchanged, itself a critical variable in conditioning inflation expectations and the chances of reflation success for the BOJ.