Consider the chart below. It illustrates cumulative growth for the G7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States) for the five years before and after the 2007-2008 financial crisis.
One can see that Italy is the only G7 economy that has contracted over the past five years, and in contrast Germany is also an exception as growth over the past five years has been stronger than the five year period through to the end 2007.
The others nations, bar Canada, have seen a reduction in growth. Canada’s economy has expanded by the exact same degree.
Time lags
The financial crisis may have been felt during 2007-2008. However, even if policy were adjusted immediately, a corrective recovery does not occur in the same or even following period.
Firstly, policy is rarely adjusted immediately as there is a “recognition lag”; the time that lapses before the authorities determine that there is a need to make a change in economic policy. Why is this? Data collection is often well behind the actual event and it can be tricky to separate random fluctuations and fundamental shifts in economic trends. The time until the next election will be influential, however, as governments tend to adopt a “wait and see” approach. The other reason for a delay is down to the “decision lag” – the period between when the need for action is recognized and when it is taken. This tends to be equal in duration for both monetary and fiscal policies; however, practice has shown that in all areas except the Eurozone, the decision lag is usually considerably shorter for monetary policy.
Because of these lags, if one look at G7 GDP growth one can see that there was a lag of 18 to 24 months from the financial crisis to the severe decline in G7 GDP growth and then the subsequent, slow recovery.
What is normal?
Canada actually makes for an interesting case at this point in the discussion. If the cumulative GDP growth in Canada for the five years either side of the financial crisis is the same, would it not be fair to expect, ceteris paribus, that the benchmark rate set by the Bank of Canada would be set at the same level now as it was before?
If we can agree that the crisis was beginning in 2007, then in January 2007 the benchmark rate deployed by the Bank of Canada was 4.25%, now in December 2014 it is just 1.00% after having been cut as low as 0.25% from May 2009 to May 2010 after GDP growth was booked at -8.99 in Q1, 2009.
Benchmark rates before the lowest economic ebb in Canada were 400 basis points above the minimum. However, now, they are just 75 basis points above. Clearly we are far from conditions where everything else is equal, after all 43.4% of Canadian exports come from basic resources and energy.
More than six years after the financial crisis plunged the world into recession, monetary policy, not just in Canada but everywhere else, looks nothing like it did before those events.
Nation/region Pre-crisis Rates Post-crisis Rates Difference, bp
Percent Percent Japan 0.50 0.00 - 50 Canada 4.25 1.00 -325 Eurozone 4.25 0.05 -420 USA 5.25 0.25 -500 UK 5.75 0.50 -525
Rates to rise in 2015?
It is forecast that the Federal Reserve in the US and the Bank of England in Britain will look to alter their benchmark rates higher next year. However, don't expect that they will even consider for a moment moving borrowing costs anywhere near pre-crisis, inflation-fighting levels.
These two central banks will not only be considering the timing of a rate rise, but they will also be mindful of when they can begin reducing their balance sheets by unloading a proportion of the financial assets they have acquired in their respective domestic markets. In contrast, we know the Bank of Japan will be an aggressive acquirer of more Japanese government bonds, given that conventional monetary policy is exhausted. Rates have been at zero since October 2010.
As for the ECB … well, that situation is up in the air, however, maybe Mario Draghi will shed more light on its balance sheet expansion plans this coming Thursday afternoon. That is if Bundesbank president Jens Weidemann lets him.
The economic recovery across the G7 is proving to be slow and far from certain, especially in areas where structural economic reform is not being delivered by national governments. So much so that there is a concern that, even in the UK and US, GDP growth will only continue to be felt so long as monetary accommodation is held the current ultra-accommodative levels.
Indeed Federal Open Markets Committee chair Janet Yellen said on November 7 at a central bank conference in Paris: "Given the slow and unsteady nature of the recovery, supportive policy remains necessary… monetary officials should keep trying extraordinary measures especially because fiscal policy today remains somewhat contractionary.”
Balance the books or stimulate growth
In the Eurozone there is a hot and ongoing debate between those member nations, led by France and Italy, that support the ECB engaging in sovereign bond asset purchases and more state spending to boost growth and employment. They are confronted by Germany and other hard line northern states – Austria, Finland and the Netherlands – that fear that sovereign debt asset purchases will open the door to bond mutualisation and moral hazard at a time when France will not reform and Italy is dragging its feet.
The recent mid-term elections in the US saw the Republicans gain control of Congress and the Senate. It is unimaginable that they would be willing to allow the Obama administration to write blank cheques on pork barrel spending and bridges to nowhere for its final two years. So in the two largest economic blocs of the world, let alone the G7, much of the economic heavy lifting will have to be done by central banks creating a base for low rates to be set on commercial lending programmes.
In Japan, Prime Minister Shinzo Abe’s fiscal stimulus plan has been blunted by a consumption tax increase that went into effect in April. An unexpected slip into recession dealt his flagship economic policies a blow, as the majority of the electorate have said that the economy and jobs were the main issues for them. Now with an eye on securing a new long-term mandate to see the policy of “Abenomics” through, the Prime Minister has called a snap general election for December 14th. He hopes he can bolster support for the sweeping economic reforms he has introduced since taking power in 2012.
The UK will have a general election on May 7 next year, and it looks as if, from what has been announced ahead of the Autumn Statement this afternoon, it will most likely be the final major collaboration of the Conservative/Liberal-Democrat coalition partners ahead of the election campaign. The deficit has not been reduced in one term as was promised in the 2010 Conservative campaign, and so we now see the coalition parties keen to talk about the spending plans they have, which are targeted as election sweeteners.
Toward the end of next year, on October 19, Canada will go to the polls and the Conservatives are lagging behind the Liberal Party. As a result, the usual fiscal conservatism of Prime Minister Stephen Harper has been replaced by news that there will be a $5.8 billion boost to mainly renew infrastructure across the country, with more than half to be spent the next three years.
It appears that regardless of what the respective central banks in each nation try to do, the real key to the nature of any economy recovery is coloured by the politics of the day and the timing of the next general election.
The International Monetary Fund in its October forecast said that the global economy will expand 3.8% in 2015, up from an estimated 3.3% for 2014 but below the great growth years of 2004 to 2007. In that four-year period, growth was 4.9% or higher.
Monetary policy scramble
The evidence is that the US economy is accelerating; the Eurozone is slowing, with growth there vanishing in the third quarter as deflation looms ever larger. Japan is in recession again and so one begins to question if G7 central banks face an impossible challenge.
Often it is said that central banks do not have an interest or a responsibility for the level of their respective nations exchange rate. However, I think that is disingenuous as indirectly intervening on the foreign exchange markets has been a well tried and tested tool for controlling currencies and preventing importing inflation. In these times of low inflation, it is clear that even though Mario Draghi will deny it, his action regarding the refinancing rate, deposit rate and the programme of asset acquisition has softened the euro.
Next year may well see the G7 central banks as central agents in a currency war of sorts as the euro and yen are deliberately weakened, in an actively managed attempt to avoid a slide into deflation. However, a potential problem in the view of a firmer dollar is that leading banks such as Morgan Stanley say price increases are running below central bank targets in virtually all developed markets. They predict the Fed won’t raise its benchmark in 2015, and in the UK the Bank of England will wait for the final quarter to do so.
That should bode well for equities as stock markets have become accustomed if not dependent on the support of accommodative monetary policy. If it is the case that the G7 indexes are only high because of the drip feed of $200 billion globally being pumped into the system every quarter can the central banks even consider raising rates? One only has to recall the October retreat that was sparked by a fear of reduced central bank support.
The recent rebound was driven by – the cynics would say – expectations that the Bank of Japan and ECB would do more. It remains to be seen how badly Eurozone assets – both debt and equity – will react if Draghi disappoints come Thursday.
Macro-prudential surveillance squad
The Fed is actively monitoring markets to identify early signs of asset bubbles that may have been inflated by the looseness of rate policy. Fed chair Janet Yellen has already warned Congress that lower-rated corporate debt and leveraged loans valuations have appeared. At the Bank of England the governor, Mark Carney, chairs a committee that makes regular assessments of hazards that are building within the financial system. One current ongoing operation is to pacify the pressure of property values, by limiting the use of highly geared mortgages that pave the way for too high a level of consumer debt.
Bank of Canada governor Stephen Poloz recently said that: “central banks will now and forever be putting weight on financial stability issues or risks when making their decisions … central banks were first invented for what we’d now call financial stability reasons … We’ve come full circle. We’re back to our roots.”
The risk is that if rates are left too low for too long for fear of destabilising the financial asset markets, and hence economic growth, that the current leaders of the G7 central banks will be judged as having left monetary policy too loose. That could fuel more than a single bubble.
However, it would be a brave central banker who would stare down his finance minister by acting proactively to drain liquidity out of the system. The macro fundamentals of the modern pro-business economy are becoming more complex each day, as each system is not hermetically sealed. Exogenous effects are equally as deterministic as the endogenous. So if my trading partner has a problem, I have a problem too, and any definition of what is normal is increasingly theoretical as against empirical.
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