We are all Sectoral Stagnationists now

The  decision by the  US Federal Reserve to leave monetary policy unchanged at the recent FOMC meeting was interesting on a number of fronts, including the emphasis given to the global situation in informing  the outcome. OF more significance was the economic forecasts supplied by the 17 Fed members in confirming a trend evident for some time- the US Central Bank, like other policy makers  across the world, has become increasingly gloomy about the medium term outlook for growth, and as a corollary expects interest rates to remain much lower than generally seen in the post-war era. That view has been around markets and academia  for a while but it now seems to have permeated official thinking in a serious way.

Secular Stagnation is the thesis that growth in the medium term  will be weaker than we have become accustomed to, certainly in the developed world and possibly also in many parts of the developing world. Labour force growth has slowed in the West and in some cases is already falling, which reduces potential GDP growth, but a feature of the stagnation view is an emphasis on the savings/ investment balance. Ben Bernanke was one of the more prominent economists drawing attention to global excess savings, which he saw as putting downward pressure on interest rates  and sought to link this to the observed trend decline in longer term bond yields in the US, the closest approximation to a global risk free rate of interest. More recently, others have drawn attention to  investment spending, which is weak by historical standards,  which is put down to a number of factors, including  changing technology ( the capital spending generated by the internet versus railways or electricity for example) or simply a  perceived decline by companies  in profitable investment opportunities. Capital spending by governments, once the mainstay of Keynesian expansionary fiscal policy, has also fallen foul of the new orthodoxy ,  which extolls retrenchment.

The result of this combination of higher savings and lower investment demand is a decline in the equilibrium real rate of interest. Indeed, some argue, like Larry Summers, that the equilibrium  real rate may now be negative. With nominal rates now at the zero bound the only way to get negative real rates is to generate some inflation but so far policy makers have not succeeded in that aim, with inflation closer to zero than to official targets in many economies. Indeed, with deflation in some cases, real rates are positive.

Given that background it is interesting to observe the evolution of the Fed’s thinking over the past few years. The long term rate of  US GDP growth, which used to be thought of as around 2.7%, is now put at only  2% in the latest Fed projections, although that is still  deemed consistent with inflation picking up to the 2% target. The forecast Fed funds rate ( the Dot Plot) in the long term has also fallen, to 3.5% from around 4% a few years ago, which implies a 1.5% equilibrium real Fed Funds rate( 3.5% nominal less 2% inflation).

The Fed’s view on the timing in reaching this target has also changed appreciably; a year ago the median expectation was a  Fed Funds rate of 1.375% by the end of 2015 and that is now 0.375% (with only two meetings remaining this year).  Similarly, the current median expectation for official rates at end-16 is 1.375% against 2.875% twelve months ago. What is also striking is the distribution  of the forecasts for next year, with a range of -0.125% to 2.875%.

Equity markets did not react well to the FOMC leaving rates on hold, which implies that it is  the Fed’s nervousness about the short-term outlook that is dampening investor spirits, offsetting any positives from the absence of tightening. The Fed’s gloomier  longer term  view is  perhaps more significant , however, in that we are all Secular Stagnationists now it would seem.


Irish growth surge begs questions about upcoming Budget

The Irish economy is now growing at a very rapid pace, both in real and nominal terms, and much faster than envisaged by consensus forecasts or by the Irish Government when framing the 2015  or indeed  the 2016 Budget.  Real GDP grew by 1.9% in the second quarter,  leaving the annual increase at 6.7%, while  first quarter growth was revised up to 2.1% and the annual change to 7.2%. That means that  growth averaged 7.0% over the first half of 2015  so forecasts for the year as a whole are likely to move up to at least  6% or higher. Moreover, nominal GDP is soaring, rising by an average  12.5% in the first half of the year, and GDP for 2015 may exceed €210bn,  implying a General Government debt ratio below 100%, from 107.6% last year.

The initial recovery in the Irish economy was driven by exports but of late domestic demand, which is more labour intensive, has moved to the fore. The external trade data  is still extremely strong,  albeit affected by recent Balance of Payments  (BoP) changes, and while exports  still greatly exceed imports in absolute terms,  import growth is now outpacing, so reducing or even eliminating the positive  contribution of trade to GDP. In q2 imports rose by 6.3%  so  exactly offsetting the impact of  a  5.4% increase in exports. Looking at the annual change in q2, export growth of 13.6% was dwarfed by a 16.9% rise in imports, resulting in a  negative (-0.4%) contribution to GDP.

Domestic demand was generally expected to pick up in 2015 but  the data has also  surprised, with the second quarter seeing a 4.8% rise, leaving the annual increase at an extraordinary 10.1%. Investment spending was the main driver, rising by over 19% in the quarter and by 34% over the year. Construction output is growing but the main factor was a surge in spending on machinery and equipment, although this is very volatile, particularly given the influence of aircraft orders. One puzzling feature in terms of the other components of demand is the performance of consumer spending, which has also picked up but at a slower pace than indicated by retail sales; consumption rose by just 0.4% in q2  and the annual increase slowed to 2.8% from 3.7% in q1.

Commentary on the national accounts often includes caveats about the GDP numbers, with some preferring GNP , the income of Irish residents, as a better measure. Yet growth is also extremely strong using that metric, averaging 6.7% over the first half of the year, although multinational profit outflows did pick up in q2 and the differential between the two measures may widen over the rest of the year.

Irish GDP is now  5.7 % above the previous peak but the unexpected strength of activity in 2015 raises a number of policy issues. On the face of it the economy is growing at a rapid clip and  employment is rising strongly , which would not signal the need for a further boost  to demand from fiscal policy in 2016, particularly as monetary policy is extraordinarily easy and the exchange rate has depreciated. The Government has already received advice from a variety of quarters urging little or no stimulus and the GDP  figures might serve to reinforce such views. Against that, CPI inflation is around zero, wages are only beginning to rise, credit is still contracting and Ireland ran a BoP surplus of  €4.3bn over the first half of the year, a picture hardly consistent with an overheating economy.

There is also an election due within six months, of course, but times have changed in that the Government is now constrained by EU fiscal rules, including one which limits the growth in real exchequer spending to the growth in potential GDP. The latter figure  is determined by the European Commission (EC), using a 10-year average ( including estimates of the current year and forecasts four year ahead) and as it currently stands it means virtually  zero growth in real spending in the 2016 Budget. This  real limit is translated into a cash figure by using the EC’s forecast for price rises across the economy ( the GDP deflator) which is currently  1.6%,  giving a permitted  expenditure figure of €1.3bn to allocate between spending increases and tax cuts.

Yet the GDP deflator is currently rising at an annual 5.2%, so the 1.6%  forecast for 2016 looks too low. Moreover, the potential growth rate  forecast also looks less credible, given the 2015 data. For example, Ireland’s potential growth rate for the year  was put at 2.8% , which implies that the economy may currently be operating 3-4% above capacity, given that the EC assumed  the economy was around full employment in 2014, which  is not consistent with the  observed wage and price behaviour.

There is now little more than a month to the 2016 Budget, so interesting times ahead, although whatever transpires, a buoyant economy can no longer translate into the tax and spending package we might have seen in the past.