Markets are making the most of the Goldilocks scenario
The International Monetary Fund’s latest update to its World Economic Outlook (WEO) is titled A Firming Recovery. It answers the question posed by the title of its April 2017 World Economic Outlook, Gaining Momentum? in the affirmative. The IMF now feels bold enough in its growth forecast to drop the question mark.
Global growth, according to IMF, is estimated to pick up to 3.5% in 2017 and a bit more to 3.6% in 2018, from 3.2% in 2016. There’s no change in the growth forecast from the April WEO, but they have changed the outlook for individual countries, in particular, paring their growth estimates for the US and increasing that for China.
But while global growth projections have remained unchanged, IMF has reduced its expectations of inflation for both advanced and emerging market economies for 2017 a bit, perhaps the result of revising downward their forecasts for both oil and non-oil commodity prices.
It’s not only IMF that predicts firmer growth and low inflation. Earlier this month, the Asian Development Bank, in a supplement to its Asian Development Outlook, raised the growth rate for the developing countries in Asia for the current year from 5.7% to 5.9% while reducing its inflation forecast for the region from 3% to 2.6%. The link between higher growth and rising inflation seems to be broken.
That is precisely the conclusion the Bank for International Settlements’ (BIS) Annual Report, published last month, came to. It said the global cyclical upswing has strengthened, while the “link between economic slack and price inflation has proved rather elusive for quite some time now”. The report drew attention to long-term forces that were suppressing inflation, in particular the inability of labour to bargain for higher wages. BIS concluded, “while an inflation spurt cannot be excluded, it may not be the main factor threatening the expansion, at least in the near term. Judging from what is priced in financial assets, also financial market participants appear to hold this view”.
The combination of higher-trend growth and below-trend inflation is what the folks at the Bank of America-Merrill Lynch fund manager survey call the Goldilocks scenario. Higher growth feeds through into higher corporate earnings, while low inflation holds back the central bank from raising interest rates. For financial markets, it’s the best of all possible worlds. With central banks reluctant to withdraw their monetary methadone, the party in the asset markets can get even wilder.
Even more bullish for asset prices is the argument that, if as BIS contends, low inflation is a structural phenomenon, then the high valuations in several markets would find a rational underpinning. Chart 1 shows the massive rise in central bank balance sheets since 2007, while Chart 2 shows real policy rates are still negative in the advanced economies, underlining the fact that monetary policy remains exceptionally loose and asset valuations are a function of that. What’s more, the charts suggest it’s likely to be a very long and winding journey to normalization.
The BIS report emphasizes the dangers of such unbridled optimism. True, the bankers’ bank feels that there may have been a structural shift towards lower inflation. But that doesn’t mean it is advocating a very gradual normalization of monetary policy by the advanced economy central banks. On the contrary, its annual report warns of the dangers of keeping interest rates too low for too long, which could increase risks to financial stability as debt increases and financial participants become complacent. It says a financial bust, rather than an increase in inflation, is the risk to markets and will be the main cause of the next recession. Nevertheless, with lower inflation, it’s very likely that interest rates are likely to remain lower for longer. The IMF WEO update takes the lower inflation expectations into account and forecasts a lower US dollar six-month Libor rate than in its April forecast. The Libor rate of 3-month euro deposits is forecast to continue to be negative in 2018, while that on 6-month Japanese yen deposits is pegged at 0.1%. Note that, at its June meeting, the Federal Open Market Committee (FOMC) pared down its estimates for both personal consumption expenditure inflation and core inflation in the US this year. There is no sign of the long-awaited Trumpflation.
For all these reasons, the markets do not expect central banks to pop the bubble any time soon. At the moment, all eyes are on the FOMC meeting on 25-26 July. The US dollar index is at a 13-month low, which suggests the markets don’t expect the US Fed to announce a date for the beginning of “The Great Unwinding” of its balance sheet at the meeting. Even if it does so, it will probably offset any such announcement with soothing noises about a glacial pace of normalization, if it is not to disrupt the financial markets. So far, central banks in advanced economies have been careful to avoid anything that could even remotely rock the boat. Markets across the world are betting that benign policy will continue.
Manas Chakravarty looks at trends and issues in the financial markets. Respond to this column at firstname.lastname@example.org.