Download Annual Economic Outlook 2016

Annual Economic Outlook
2016
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John Greenwood
Chief Economist, Invesco Ltd.
Summary
–With the US Federal Reserve (Fed) starting on a series of fed fund rate hikes from 16 December
2015, US money and credit markets will be on the path towards normalisation after seven
years of abnormally low rates. This is a sign that, despite the weakness in other developed and
emerging economies, the US is back on the road to normal growth.
– However, the key indicator to watch will be the rate of growth of bank credit. The US is the only major
economy where bank credit growth has returned to normal (6-8% p.a.) and it is critical that, in the
aftermath of interest rate hikes, credit continues to grow at roughly the same rate. If this happens,
then equity and property markets can shrug off the early phase of interest rate hikes in my view.
–Assuming no tightening of credit conditions, I expect US real GDP growth in 2016 of 2.6%, and
CPI inflation of 1.4%.
–By contrast, the Eurozone and Japan are still in the midst of extended programmes of
quantitative easing (QE) intended mainly to keep interest rates low along the length of the yield
curve (rather than directly to boost the rates of growth of money and credit), and hence to
stimulate the two economies.
–
With the Euro-area likely to grow at only 1.5% in 2016 and Japan at 1.3% and with inflation in both
economies well below 2%, the European Central Bank (ECB) and the Bank of Japan (BoJ) are at
least a year, if not more, from hiking interest rates in my opinion. In both cases there are faults in
the design of their QE programmes that need to be rectified in order to make them more effective.
–The upswing in both the economies of the Eurozone and Japan have slowed somewhat
in recent months, demonstrating that the underlying recoveries in the US and the UK are
inherently more sustainable than the - as yet - fragile upturns in the Eurozone and Japan.
–The divergent monetary policies of the Fed and possibly the Bank of England (BoE) on the one
hand and the ECB and BoJ on the other implies some further volatility in the currency, fixed
income and equity markets.
–In particular, the US dollar will probably appreciate further while the euro and the yen might
depreciate more. This may weaken the earnings of large US companies with substantial
overseas sales, but medium and smaller-size US companies should benefit from the broadening
domestic recovery.
–The overall picture globally is one in which both growth and inflation will remain subdued
against a background of several years of very low money and credit growth.
–
The UK is faced with a similar situation to that in the US - reasonably buoyant economic activity (I
forecast 2.4% growth in 2016), but accompanied by inflation well below target. This implies that the
BoE are unlikely to follow the Fed in raising interest rates until February or May 2016 at the earliest.
–In the emerging economies the slowdowns in China, Brazil and Russia are continuing to impact
commodity markets, numerous basic industries and global trade volumes. Beyond that, the
struggle among emerging market (EM) producers more generally to regain competitiveness
threatens several EM currencies with the need for further currency depreciation.
Trade-weighted value of US
Dollar against major currencies
Figure 1
US dollar likely to appreciate further
Trade-weighted value on the US Dollar
02
04
06
08
10
12
14
115
110
105
100
95
90
85
80
75
70
Source: Macrobond as at 16 December 2015.
01
Annual Economic Outlook
–The emerging economies face three key problems. First, many of them allowed excessive
rates of growth of money and credit in 2009-13; second, most are still overly dependent on an
export-led growth model; and third many of them are very dependent on commodity exports at
a time when commodity prices have slumped.
–Following the temporary recovery in the price of oil between March and May 2015 to US$6065 per barrel, prices fell again in Q3 2015 and Q4 2015, with the West Texas Intermediate
oil price falling below US$40 per barrel in December. I believe that oil prices will remain weak
(below US$60) in 2016.
–Inflation rates have continued to remain very low in most developed economies. The
widespread inflation undershoot reflects not only the direct effect of weak commodity prices
but also the persistent background of slow money and credit growth that has characterised the
post-crisis period. Only in the US have money and credit growth rates returned to normal rates.
–In spite of these short to medium term setbacks in the recovery process my long-standing view
has been that the current global business cycle expansion will be an extended one. The main
reason is that sub-par growth and low inflation would avoid the need for the kind of tightening
policies that would bring an early end to the expansion.
–It is also the case that recessions or growth weakness in the EM economies are unlikely to derail
the modest-paced recovery in the developed economies. While some companies or sectors
cannot avoid being affected by the problems of the EM, the transmission of key fundamental
forces - like monetary policy and balance sheet repair - still goes primarily from developed
markets to EM, not vice versa.
–In addition, the recovery in the US, although already six and a half years old, is only now
starting to take on the typical characteristics of a normal recovery: banks have started to
provide credit instead of the Fed, business investment is recovering and consumer spending is
regaining its normal momentum.
Figure 2
Consensus Economics
2015 Estimate
Real GDP (%)
CPI inflation (%)
US2.40.1 Eurozone1.50.1 UK 2.5 0.1 Japan 0.6 0.8 Australia 2.3 1.6 Canada 1.1 1.1 China 6.9 1.5 India 7.5 5.0 Source: Consensus Economics, Survey Date: 9 November 2015.
02
Annual Economic Outlook
2016 Consensus forecasts
(Invesco forecast)
Real GDP (%)
CPI inflation (%)
2.6
(2.6)1.7
(1.4)
1.7
(1.5)1.1
(1.0)
2.4 (2.4)
1.3 (1.2)
1.3 (1.3)
0.8 (0.8)
2.6 (2.4)
2.4 (2.4)
2.0 (2.0)
1.9 (1.6)
6.5 (6.6)
1.9 (1.6)
7.8 (7.3)5.3
(5.0)
United States
With the gradual healing of private
sector balance sheets, US growth is at
last returning to normality after nearly
seven years of balance sheet-constrained
weakness. The weather-induced weak real
GDP of 0.6% (annualised) in Q1 2015 was
followed by a bounce back of 3.9% in Q2,
and a more normal 2.1% in Q3. For the
year as a whole average GDP is likely to be
2.4%, above the OECD estimate of current
US potential growth (1.6%).
ISM manufacturing index
ISM non-manufacturing index
Figure 3
US: Two-speed growth rate
US: ISM manufacturing and non-manufacturing indices
08
09
10
11
12
13
14
15
65
60
55
Since the third phase of QE ended in
50
October 2014 the recovery in the US
economy has been hugely assisted by
the return of commercial banks to the
45
business of credit creation. For example,
since the start of 2015 total loans and
40
leases of US commercial banks have been
growing at a steady 8.0%, ample to fuel
35
the liquidity needs of the economy. With
the Fed having now started the process
of rate normalisation, the key issue will
be whether US banks continue to create
Source: Macrobond as at 16 December 2015.
credit at a similar rate, or whether they
curb the rate of credit creation. Credit
growth of 8% per annum would be enough, However, the economy is showing signs of a two-speed split, with manufacturing weakening and
if sustained, to support nominal GDP
services strengthening. For example, industrial production slowed from a year-on-year growth of
annual growth of 5-6%.
4.6% in December 2014 to only 0.3% in the year to October 2015, reflecting the decline in shale
oil investment in the US, the strong US dollar, and the excess capacity in basic industries abroad,
In addition, labour market data have
especially in China. Similarly, the ISM index of manufacturing declined to 48.6 in November
continued to be buoyant but not showing
(indicating a majority of industries were contracting) from 55.1 in December 2014. By contrast,
any signs of overheating. For example,
the ISM non-manufacturing index has remained above 55 since April 2014. In summary, given the
non-farm payrolls increased by an average dominance of the service sector, this adds up to a recovery that is now self-sustaining even without
of 210,000 per month for the year to
Fed asset purchases, although it is unlikely to become exuberant any time soon in my view.
November, and the unemployment rate
fell from 5.8% in January to 5.0% in
US consumer spending expanded from 60% of GDP in the 1970s to 68% of GDP by the time
November. Average private non-farm
of the financial crisis in 2008-09, helped by a major increase in consumer indebtedness over
weekly hours worked have held steady at
the subsequent three decades. Since the crisis spending has remained at roughly 68% of GDP,
33.7 hours, returning to their pre-crisis
but households have deleveraged relative to income, putting an effective ceiling on consumer
trend. Moreover, growth in average hourly spending. Unless consumers are prepared to start adding to their indebtedness once again,
earnings of production and non-supervisory consumer spending will now be limited to the rate of growth of personal incomes. Consistent with
workers has averaged fractionally less
this analysis, personal consumption spending grew 3.4% year-on-year in Q3 2015, slightly less
than 2.0% during 2015 and does not
than personal incomes in the year to October 2015 which grew at 4.6% in nominal terms.
appear to be showing any clear uptrend.
Furthermore, the labour force participation Investment spending also remains subdued, gradually climbing from its post-crisis lows of 13.5% of
ratio has continued to decline from 62.9%
GDP in 2010 to 16.3% of GDP in Q3 2015. Non-residential private fixed investment surpassed its
in January to 62.5% in November.
pre-crisis peak in late 2013 and has continued to move gradually upwards, but the corporate sector
is still showing a clear preference for financial investment in the form of share buy-backs or mergers
and acquisitions rather than investment in physical plant and equipment. Housing investment
experienced a particularly weak first quarter, but since then it has continued its gradual recovery,
showing a modest improvement over 2014 as measured by a composite of housing starts, permits
and completions. These data suggest an economy that is gradually returning to normal rather than
surging ahead on the basis of low interest rates. For 2016 I expect 2.6% real GDP growth.
On the inflation front consumer prices have continued to surprise most forecasters on the
downside, recording a 0.2% year-on-year increase in October 2015, and 1.9% when volatile food
and energy prices are excluded. This is usually explained by the fall in commodity prices over the
year, especially oil prices, but the truth is that weak commodity prices are a symptom of a weak
global economy, which in turn is a result of slow growth of money and credit. With no acceleration
in money and credit growth it is unlikely that inflation can rise significantly. For 2016 I forecast a
1.4% increase in headline CPI inflation.
03
Annual Economic Outlook
The Eurozone
Eurozone real GDP growth has remained anaemic in 2015, slowing from 0.5% quarter-on-quarter
in Q1 to 0.4% in Q2 and 0.3% in Q3 (respectively 1.3%, 1.6% and 1.6% year-on-year). However,
deflation risks have diminished thanks to the depreciation of the euro since the first three months
of 2015 and the eventual adoption of QE policies by the ECB, starting in March. I forecast 1.5%
growth for the Eurozone in 2016.
For most of 2015 economic activity has been weaker and inflation lower than the authorities at the
ECB had hoped, with the ECB revising down its forecasts and President Mario Draghi announcing
a modest extension of the QE programme on 3 December. Although the amounts purchased each
month by the central bank remain unchanged at €60 billion, the range of assets to be purchased
was widened to include provincial or regional authority debt instruments, and the date for ending the
asset purchases was moved out 6 months until “the end of March 2017, or beyond, if necessary”.
The principal payments on maturing holdings would henceforth be re-invested and the interest rate
on the ECB’s deposit rate facility was lowered by an additional 10 basis points to minus 0.30%. As
explained in past issues of this publication, the QE programme continues to be less stimulating to
markets and the broader Euro-area economy than it should be due to basic design flaws.
In the final quarter economic activity may have improved somewhat, as suggested by the small
rise in the composite Purchasing Managers’ Index (PMI) to 53.9 in October and 54.2 in November.
Across the major economies of the Euro-area the PMIs are generally above the 50 line that
separates expansion from contraction, with composite indices for Germany at 55.2 in November,
54.3 in Italy, and 56.2 in Spain. Only France is significantly weaker at 51.0 in November.
The German Ifo index of business conditions recorded its highest level for the year (109.0) in
November, and has been on a rising trend since October 2014. However, the labour market in
Europe continues to make only very slow progress with unemployment falling from a peak of
12.1% in June 2013 to 10.8% in September 2015, contrasting sharply with the steep declines seen
in the US and the UK over the past five years.
Figure 4
Eurozone: ECB’s QE policy not gaining full traction
Eurozone total assets of ECB and deposits in M3 (% YOY)
11
12
13
14
Total assets of ECB
Deposits in M3
15
60
Start of QE
50
40
30
20
10
0
-10
-20
Source: Macrobond as at 16 December 2015.
One factor which perhaps should have made a greater contribution to Euro-area growth was the
depreciation of the euro from US$1.25 to 1.05 by mid-March, subsequently fluctuating in the
range 1.15-1.05 for the rest of the year. Exports from the Euro-area have only picked up since
mid-2015, although the growth rate in September was still only 6.3% year-on-year. The main
explanation is that without volume growth abroad, price changes alone will do little to boost
demand from Europe. Consequently, Eurozone exports, in line with the sluggish performance of
global trade in recent years, were essentially static between 2012 and mid-2015. Meantime the
current account has moved to a surplus of 2.9% of GDP, mainly due to weak imports.
In addition to these cyclical problems, the repair of balance sheets in the Eurozone is proving slow,
although given the fiscal squeeze imposed by the authorities this is not surprising. Only in Spain,
Ireland and one or two sectors elsewhere such as the German and Italian financial sectors has
indebtedness declined relative to GDP.
Despite the ECB’s QE measures, the Euro-area is still dangerously close to deflation. In January 2015
the headline CPI had fallen to -0.6% year-on-year, and in November it was still only +0.14%, while the
GDP deflator was 1.3% in Q3. Importantly the rate of growth of money and credit in the Eurozone
has been improving, but since it takes two years for the full effects of faster money growth to feed
through to inflation, it will be another year before positive inflation rates can be assured. Meantime
the weakness of commodity prices is having a temporary downward effect on reported inflation. The
ECB must therefore encourage faster growth of broad money and credit than it has allowed so far. I
forecast the inflation rate of the Eurozone as a whole will be 1.0% in 2016 - still well below target.
04
Annual Economic Outlook
United Kingdom
The recovery of the UK economy continued in 2015 but slowed modestly from the strong pace seen
in 2014. On a quarter-on-quarter basis, growth accelerated to 0.7% in Q2 2015, or 2.4% year-onyear, but slowed to 0.5% quarter-on-quarter in Q3, or 2.3% year-on-year. As in previous years of this
recovery it has been services that have been leading the way, with manufacturing and construction
lagging behind. Viewed from the expenditure side, personal consumption has been firm, helped
by the decline in the inflation rate which has boosted real wages. However, the fastest growing
expenditure component of GDP in 2015 has been capital investment by businesses, averaging 4.7%
in real terms over the past four quarters compared with 3.0% for final consumption expenditure.
Construction
Manufacturing
Services
GDP
Figure 5
UK: Services leading, manufacturing and
construction lagging behind
UK: Real GDP by value added (2008 Q1=100)
08
09
10
11
12
13
14
15
120
115
110
105
100
95
90
85
Source: Macrobond as at 16 December 2015.
The contrast between strong services and weaker manufacturing is reflected in the relative
performance of the PMI indicators. While the composite PMI index (which includes manufacturing
and services but not construction) showed an expansion to 55.8 in November, the manufacturing
PMI was 52.7 whereas the services sector recorded an advance to 55.9. Both sets of indicators
implied some slowing from the stronger expansion earlier in the year.
The key to stronger services and consumer spending has been the gradual upturn in wages, which
increased by 3.0% year-on-year (inclusive of bonuses) in the three months July-September in
both nominal and real terms (since year-on-year CPI inflation was zero in the those three months),
combined with the continuing growth of employment. For example, using the Labour Force Survey
data, the number of people in full-time employment increased in the year to July-September by
273,000, and by 146,000 in part-time jobs. Together these figures account for the increased
purchasing power shown by UK consumers over the year, though the falls in energy prices towards
year end could boost consumer spending even further.
As noted, investment spending by businesses has been growing steadily and order books reported by
the Confederation of British Industry have been firm, though softening a touch through 2015. Some
of the slowdown is probably due to the stronger level of sterling which has appreciated by 9.7% on a
trade-weighted basis over the year to December. Reflecting the growth in the number of households
and population, as well as the shortage of new houses and apartments coming on to the market, house
prices had risen by 5.6% year-on-year in Q3 2015 (according to the ONS mix-adjusted house price
index). With the exception of Scotland, Wales and the north-east of England, house prices rose across
the board, helped in part by the gradual rise in mortgage lending approvals since the start of 2015.
Looking ahead the pace of economic growth is unlikely to change much from here, with a range
of surveys and indicators suggesting that growth will be maintained at close to 2.5%. Low rates
of money and credit growth over the past three years combined with the strength of sterling will
ensure that headline inflation will remain low through 2016.
Turning to monetary policy, the BoE will almost certainly not follow the Fed in raising rates for
several months in my view. First the reported CPI inflation rate in the UK is much lower than the
2% target level; second money and credit growth are subdued; and third raising rates would tend
to strengthen sterling even further – an unwelcome step as far as the authorities are concerned.
Given that the Bank tends to adjust rates only after its quarterly Inflation Reports, it seems unlikely
that there will be a rate rise in the UK until the May or August 2016 Inflation Reports at the earliest.
For 2016 I now expect 2.4% real GDP growth and 1.2% CPI inflation.
05
Annual Economic Outlook
Japan
The signature policies of Prime Minister Shinzo Abe to revive the economy consist of three “arrows”:
a stimulative monetary policy, a reconstruction of Japan’s fiscal accounts and a set of structural
reforms. While some progress has been made under the first two parts of the “Abenomics” plan
(monetary policy and taxation reform), the third arrow, which emphasises reforms to labour
markets, company tax and competition, has been more politically difficult and slower to emerge.
First, on the monetary front, although the BoJ has more than doubled the size of its balance sheet by
means of bond (and other asset) purchases, the commercial banks have not expanded their balance
sheets at a faster pace than previously. At the end of November, Japan’s money supply (M2) had
increased by only 3.3% year-on-year, while bank lending had increased by 2.5%. Total bank credit,
which includes bank holdings of securities, has actually declined since March 2013 when Governor
Kuroda took over at the BoJ.
The second “arrow” of Abenomics, fiscal policy, turned restrictive in 2014 when a 3% increase in
the consumption tax was imposed from 1 April. Personal consumption spending, which had surged
ahead of the tax, plunged - in Q3 2015 it was still below its level in Q3 2013. In a low growth economy
like Japan without strong income growth the effect of a 3% tax hike has been painful and sustained.
In October nominal retail sales increased by 1.6%, but it is too early to judge if this erratic series
points to any sustained recovery of consumer spending. Consensus estimates forecast year-on-year
increases in real consumer spending of 1.3% in 2016.
Recession
Figure 6
Japan: Real GDP has not yet recovered to its pre-consumption tax level
Japan real GDP (at constant prices)
07
08
09
10
11
12
13
14
15
540
530
520
Consumption tax
510
500
490
Source: Macrobond as at 16 December 2015.
JPY, trillion
Real GDP growth has been highly erratic in the past three years, in part due to the imposition of the
consumption tax, but also due to changes in the value of the yen and its impact on external trade.
After two steep declines in Q2 2014 and Q3 2014, the annualised growth of real GDP has been
1.8%, 4.4%, -0.5%, and 1.0%. Industrial production growth has also been highly variable around
a very low growth rate compared with the past. With short supply chains in Asia and more rapid
changes in consumer tastes it is unlikely that Japan will return to steady, positive growth – even
under “Abenomics”. Consensus estimates of overall real GDP suggest growth rates of 1.3% only in
2016, in line with my forecast.
The third “arrow”, structural reform, consists of a long list of initiatives proposed by PM Abe’s
closest advisers as well as by government departments. Very little of substance has yet been
implemented. There are almost certainly substantial gains to be achieved through changes to
labour market regulations (including immigration) and enhancing domestic competition with freer
entry into industries, improved pricing surveillance and new approaches to regulation. However,
vested interests such as farmers, truckers, doctors and other groups of professionals have built
strong political lobbies and the PM has not felt able to confront them.
On the external front, the depreciation of the yen in 2013-14 is at last starting to impact the trade
and current accounts. Both have improved relative to GDP, providing a boost to growth. After the
tsunami and Fukushima nuclear disaster the external accounts worsened but the combined effects
of a weaker yen and lower commodity prices have turned things around for Japan. Although the
trade balance is still marginally in deficit, Japan is now running a current account surplus of close
to US$300 billion or 0.75% of GDP.
With growth low but erratic and inflation well below the BoJ’s target rate of 2%, the achievements
of “Abenomics” are looking distinctly limited.
06
Annual Economic Outlook
China and non-Japan Asia
Although official figures show that China’s growth remained steady at or near 7% throughout
2015, most observers would consider that the economy has continued to slow. This is partly a
problem of perception, and partly of inadequate statistics. There is no doubt that China’s northeast region, where State Owned Enterprises involved in heavy industries such as coal, steel
and aluminium smelters are concentrated, have been in recession, overburdened with excess
capacity and accumulated debt. This is easy to see both on the ground and in the statistics for
commodity prices, freight shipments and falling output. However, the faster growing service and
light manufacturing industries of the south-eastern provinces are still growing vigorously, but
there are few “hard” data series to confirm this impression. Internet-based services and deliveries
are flourishing - as in other economies - but government and private industry sources have few
satisfactory data sources to confirm the growth momentum in these new sectors.
Official data such as the non-manufacturing PMI, which was 53.6 in November, or the
manufacturing PMI which was 49.6 also in November confirm the weakness in manufacturing
compared with the relative strength in services. The unofficial Caixin PMIs are broadly in line with
these indices, but show a steeper decline in manufacturing (48.6 in November after a recent low of
47.2 in September) and a weaker trend in services (51.2 in November after 50.5 in September).
Given the need to deleverage the economy after several years of very rapid credit growth and the
slow growth of China’s more developed trading partners, it seems inconceivable that there could
be any rapid return to pre-crisis growth rates anytime soon. For 2015, the official growth figures
are expected to be 6.9%, according to Consensus Economics, and I forecast 6.6% in 2016.
National average
Service sector six
North China six
Figure 7
China: Wage growth in north-east rust belt
lagging the service sector
Average wage growth by groups of provinces
(%, y-o-y)
Jan
12
Jul
12
Jan
13
Jul
13
Jan
14
Jul
14
20
18
16
14
12
10
8
Source: Macrobond as at 16 December 2015.
Since the authorities deliberately devalued the currency from around 6.21 per US$ to 6.386.40 in early August the currency had been held fairly stable in the range 6.30-6.40 per US$.
However, since 30 November when the IMF admitted the Chinese yuan to membership of
the basket of currencies comprising the Special Drawing Rights (SDR), the currency has been
allowed to depreciate more rapidly, reaching 6.46 on 15 December Although the SDR status has
symbolic meaning, it will probably not make much difference to foreigners’ day-to-day access
to China’s domestic capital markets. It remains the case that China’s future growth and the
internationalisation of its currency will be far more dependent on the liberalisation of China’s
domestic capital markets and the lifting of its extensive capital controls than on the recent decision
by the IMF.
Without an acceleration of money and credit growth (which is not desirable while China is
deleveraging) CPI inflation is expected to remain low. The most recent reading was 1.5% in
November, and I forecast 1.6% in 2016. Among other factors keeping inflation subdued are the
continuing declines in commodity prices which have helped push the producer price index down to
-5.9% year-on-year in November.
The remainder of non-Japan Asia is suffering from the same broad weakness in world trade that
has been holding back China’s export engine. However, with only a few exceptions, such as India,
Indonesia and possibly Korea, the regional economies do not have large enough domestic markets
to provide a countervailing locomotive effect. Consequently the entire region is watching and waiting
for progress in the developed economies, especially the US, to begin a more vigorous upturn.
07
Annual Economic Outlook
Commodities
I have been bearish on the outlook for commodity prices over the past two years. In recent months
there have been further significant falls in most commodity markets. Most strikingly the oil price
has fallen steeply with Brent crude dropping from US$115 per barrel in June 2014 to US$64
in December 2014 and below $40 in December 2015. This is a direct result of weak demand in
China, other emerging economies, and the Euro-area, together with the consequence of new
supplies from US shale oil and gas suppliers, plus the decision of OPEC not to cut production.
Other industrial commodities have seen comparable price falls. For example, imported iron ore in
China has fallen from US$180 in 2011 to below US$40 per metric tonne in December 2015 while
Australian coking coal prices have fallen by comparable amounts.
Finally, precious metal prices have been declining with gold and silver prices subdued, but steep falls
in platinum prices over the past five years, and a 40% fall in palladium prices over the past year. This
is all consistent with the relative softness of global demand resulting from the sub-par growth of
major economies and the slowdown of emerging economies as they reduce emphasis on export-led
growth models. Looking forward, commodity markets are not likely to strengthen over the next year
as inflation will remain low and economic activity levels will moderate at best in my view.
EM Commodity
producers’ exports
EM Manufacturing
economies’ exports
Figure 8
EM Commodity exporters hit much harder
than EM manufacturing exporters
Exports of “manufacturing” and “commodity”
Emerging Economies (Jan 2009 = 100, 3MMAV)
09
10
11
12
13
14
15
300
275
250
225
200
175
150
125
100
Source: Macrobond as at 16 December 2015.
08
Annual Economic Outlook
Conclusion
In the financial markets there is a widespread misunderstanding about the stance of monetary
policy. Most economists and analysts tend to judge monetary policy by the level or direction of
interest rate changes. However, interest rates are not a good measure of the stance of monetary
policy. If monetary policy i.e. monetary growth is eased, interest rates will fall initially but later,
after the economy recovers and inflation rises, rates will rise. The longer term and more important
effect (the “Fisher effect”) of easy money is higher interest rates not lower rates.
Conversely, if monetary policy is tightened interest rates will rise initially, but then after the
economy has slowed and inflation has fallen, interest rates will fall. So the longer term and more
important effect of tightening monetary policy is lower rates not higher rates. That is why interest
rates today are highest in countries like Argentina and Venezuela and why interest rates are lowest
in countries like Japan and the Eurozone.
It follows that what is needed to avoid deflation is faster growth of the quantity of money. It is
not enough simply to lower interest rates to zero as the ECB has done. The reason is that by
merely following market rates downwards, central banks can remain essentially passive, failing
to provide the monetary expansion that an economy needs to grow. The low interest rates in the
Eurozone and in Japan are the result of the second phase of a prolonged period of tight money
policy - that is, slow money growth - not the first signs of easier - that is, faster money growth. It is
hardly surprising that in these circumstances Japan and the Euro-area have been confronted with
deflation in recent times.
With the Fed in the US moving to raise interest rates (to normalise but not tighten monetary policy)
in 2016, the critical issue will be whether money and credit growth can be sustained at 6-8%
p.a. (their recent growth rates). If the commercial banks are able to maintain these money and
credit growth rates, then even if bond and equity markets are jolted by the initial rate hike(s), the
economy will, in my view, be able to shrug off the interest rate hikes, expanding for several more
years before the business cycle hits a peak.
John Greenwood
Chief Economist, Invesco Ltd
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and the UK. It is not for consumer use.
The value of investments and any income from
them will fluctuate (this may partly be the result
of exchange rate fluctuations) and investors
may not get back the full amount invested.
While great care has been taken to ensure that
the information contained herein is accurate, no
responsibility can be accepted for any errors,
mistakes omissions or for any action taken in
reliance thereon.
Where John Greenwood has expressed
opinions, they are based on current market
conditions and are subject to change without
notice. These opinions may differ from those of
other Invesco professionals.
All data provided by Invesco, sourced from
Macrobond as at 16 December 2015, unless
otherwise stated.
Issued in Austria by Invesco Asset Management
Österreich GmbH, Rotenturmstrasse 16-18,
A-1010 Wien
Issued in Dubai by Invesco Asset Management
Limited, PO Box 506599, DIFC Precinct Building No
4, Level 3, Office 305, Dubai, United Arab Emirates,
Regulated by the Dubai Financial Services Authority
Issued in France by Invesco Asset Management
S.A., 18, rue de Londres, F-75009 Paris
Authorised and regulated by the Autorité des
marchés financiers in France
Issued in Germany by Invesco Asset
Management Deutschland GmbH
An der Welle 5, D-60322 Frankfurt am Main
Issued in Ireland and the Isle of Man by Invesco
Global Asset Management Limited, George’s
Quay House, 43 Townsend Street, Dublin 2,
Ireland, Regulated in Ireland by the Central
Bank of Ireland
Issued in Malta by Invesco Global Asset
Management Limited, George’s Quay House,
43 Townsend Street, Dublin 2, Ireland,
Regulated in Ireland by the Central Bank of Ireland
Issued in Jersey and Guernsey by
Invesco International Limited, 2nd Floor,
Orviss House, 17a Queen Street, St Helier,
Jersey, JE2 4WD, Regulated by the Jersey
Financial Services Commission
Issued in Switzerland by Invesco Asset Management
(Schweiz) AG, Talacker 34, CH - 8001 Zürich
Issued in the UK by Invesco Asset Management
Limited, Perpetual Park, Perpetual Park Drive,
Henley-on-Thames, Oxfordshire RG9 1HH, UK
Authorised and regulated by the Financial
Conduct Authority
CEUK701/60390/PDF/181215