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Buttonwood's notebook

2014-10-07 05:38:42

Financial markets

Monetary policy, the economy and the markets

The new trinity: Janet, Mario and Mark

Oct 2nd 2014, 16:01 by Buttonwood

EQUITY markets are showing initial disappointment at the latest announcement by

the European Central Bank that purchases of covered bonds and asset-backed

securities are on the way; it was not the big bazooka investors were hoping

for. The worry is that the ECB is too complacent about the risk of deflation

(the headline rate is down to 0.3%).

But perhaps investors have too much faith in the power of central bankers in

general; perhaps politicians have left them to do too much of the work. In

Britain, after all, the Bank of England has bought around a quarter of all

government debt and is now refunding the interest to the Treasury; we would all

like to borrow on those terms.

Stephen King, HSBC's economist, focuses on this issue in his latest research

note. He writes, in an awkward mixed metaphor, that

the idea that each central bank can navigate its way to a future economic

nirvana by doing enough to ensure sustained growth and price stability appears

to ignore the international independencies that too often upset the

policymakers' applecart

adding that

The consensus struggles to imagine a world in which central banks are doing

anything other than regaining control over prices. If inflation is too high -

as it has been in Latin America - it is bound to come back down. If inflation

is too low - as it has been in Europe - it is bound to pick up.

In fact, inflation has continued to head in the wrong direction. Here is his

table showing current forecasts for 2014 inflation and what they were in

September 2013.

Sept 2013 Now

Euro zone 1.5% 0.6%

UK 2.5% 1.7%

US 1.9% 1.9%

Eastern Europe 4.9% 5.7%

Latin America 7.0% 12.1%

If the forecasts are as wrong about 2015, as they were about this year, then

Italy and Spain will be in deflation, euro zone inflation will still be at 0.2%

and Latin American inflation will be up at 16%.

The US is one country where inflation has matched the forecasts but over at

SocGen, Albert Edwards's latest note points to the recent decline in inflation

expectations, as revealed by the gap between nominal and inflation-linked bond

yields. At the 5-year level, inflation expectations are down to 1.6% from 2%

last year and at the 10-year, they are a little over 2% from around 2.5% last

year. That is not a huge shift but it is surprising given all the talk of an

exceptionally strong recovery. As he comments

if inflation can 't regain higher ground in this cyclical recovery, what on

earth will happen when the cyclical upswing ends?

Meanwhile, currency markets are finally starting to move with the dollar making

a six-year high against the yen and a two-year high against the euro. Some

countries may be hoping that depreciation will solve their problems. But as Mr

King remarks

as both Japan and the UK have discovered, a falling currency may do little to

help improve export prospects in a world in which economic growth is in short

supply. Indeed, it may only be that a weaker currency serves to export one

country's deflationary problems elsewhere; after all, one country's devaluation

is another's revaluation.

That leads me to the very interesting Geneva report from Luigi Buttiglione,

Philip Lane, Lucrezia Reichlin, Vincent Reinhart on the debt cycle. What is

remarkable (hence the title Deleveraging? What deleveraging?) is that the ratio

of global debt (ex-financials) to GDP has increased from 174% of GDP in 2008 to

212% today. The developed market ratio is 272%, with the euro zone on 257%, the

US on 264%, Britain on 276% and Japan on 411%. Where debt has come down (thank

goodness) is in the financial sector; nevertheless, total debt (including

financials) in the developed markets is close to its peak at 385% of GDP. More

generally, there has been some reshuffling of the debt, with more owed by

governments and a bit less by the private sector. So for example, US private

debt has fallen by 16 percentage points (relative to GDP) while public debt has

jumped by 40 points.

Regular readers will recall the mantra; the likely outcomes for the debt crisis

are that economies will inflate, stagnate or default. As made clear above,

inflation is falling in the developed world so that seems unlikely; the

emerging markets may be able to inflate their debt away (again) and they have

less of it. We have only really seen default in Greece. So as the authors of

the Geneva report worry

Deleveraging and slower nominal growth are in many cases interacting in a

vicious loop, with the latter making the deleraging process harder and the

former exacerbating the economic slowdown. Moreover, the global capacity to

take on debt has been reduced through the combination of slower expansion in

real output and lower inflation.

They add that

potential output growth in developed economies has been on a declining path

since the 1980s and that the crisis has caused a further, permanent decline in

both the level and growth rate of output. Moreover, we observe that output

growth has been slowing since 2008 in emerging markets, most prominently China.

Signs of slower growth have been highlighted in a recent blog post. The

problems of high debt levels are manyfold - not least the link between debt and

asset prices. But the authors rightly highlight that debt is constantly being

rolled over; this depends on creditors having the confidence that it will be

repaid. In turn, this depends on growth expectations. So slower growth

forecasts can themselves result in a funding crisis. The question is not so

much if, but when it will happen.