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Narratives – the stories people tell about events – may influence behaviour. In future years, several narratives may very well be used when looking back at economic developments in 2020. Big, unanticipated shocks do happen. In terms of monetary policy, a ‘whatever it takes’ attitude prevails. This also applies increasingly to fiscal policy. In terms of financial markets, the dominant attitude towards risky assets is to buy rather than to say ‘bye bye’. With Next Generation EU, the European Union has again demonstrated that, under pressure, it can make big leaps forward. Finally, attention to sustainable growth has become ubiquitous. Some of these narratives provide comfort but several also come with a warning.
Until the very end, 2020 has been a difficult year, to say the least. However, there are reasons to be cautiously hopeful about the economy in 2021. Vaccination should reduce the uncertainty about the economic outlook. Ongoing fiscal and monetary support is also important. However, more than ever, caution is necessary in making forecasts. Reaching herd immunity may take longer than expected and some of the economic consequences of the pandemic may only manifest themselves over time.
In the US, the behaviour of the equity market versus the level of employment is very different in the current recession compared to previous recessions. The recession this year stands out because of its sudden, enormous job losses, which were quickly followed by a significant albeit very incomplete recovery. The equity market, after a huge drop, has rebounded swiftly and made new highs although earnings –on a 12 month moving average basis- still have to rebound. For 2021, more than anything, earnings growth matters.
The composite PMI is stabilising at the global level but this is masking strongly diverging trends. The US and China continue to improve, India is a bit weaker but still at a very high level, whereas the UK has dropped slightly below 50. The big decline occurred in the Eurozone with the index dropping from 50.0 to 45.3...
The Federal Reserve and the ECB have been highly successful in influencing asset prices as part of their effort to cushion the shock to the economy from the Covid-19 pandemic. However, one might wonder whether today’s relief could cause an investor’s headache tomorrow. The difficulty of an exit strategy does not imply that certain monetary tools should not be used in the first place. After all, they do have positive effects. However, the likelihood of a bumpy normalisation process of monetary policy calls for careful preparation by central banks as well as investors. These considerations could become particularly relevant should the recovery in 2021 end up surprising to the upside.
The prospect of the deployment of a Covid-19 vaccine has raised expectations that the stop-start cycle seen this year will make way for a lasting economic recovery in 2021. There is concern however that bringing the pandemic under control could take more time than is currently assumed in economic projections. Under such a scenario, worries about possible new restrictions would remain elevated, although one can assume that, because of vaccination, these measures would be less strict than before and more local. Nevertheless, in the more exposed sectors, investment and employment could be clear victims.
The Covid-19 pandemic has caused a decline in inflation and, in most euro area countries, an increase in the inflation dispersion between sectors. It will take considerable time until activity has been restored sufficiently to generate labour market bottlenecks, which –in the absence of exogenous shocks- are a necessary condition to see a broad-based and lasting increase in inflation. This suggests that for the coming years, we should expect inflation to fluctuate around a slowly rising trend. In the course of 2021, the unleashing of pent-up demand –under the assumption that a vaccine is sufficiently widely deployed- could cause a temporary pick-up in inflation. In this respect, a decline in the price elasticity of demand will play a key role.
The announcement that a Covid-19 vaccine that is under development is highly effective caused major reactions in financial markets, reflecting a feeling that the growth outlook has changed. The prospect of a vaccine offers hope that in the medium run activity will normalise, but the positive impact on growth will take time to materialise. Clearly, the view that better times are ahead of us very much depends on the horizon one takes. However, decisions of households and businesses not only depend on expected growth of income and profits but also on the distribution around the growth forecast. The prospect of a vaccine reduces the probability of very negative outcomes and this reduction in uncertainty should eventually contribute to a pick-up in growth.
Market action last week largely reflected expectations of how the result of the US elections would shift the balance between fiscal and monetary stimulus. Federal Reserve Chair Powell insisted on the need for more fiscal policy support but also hinted that, if need be, more monetary easing would occur. In the UK a coordinated approach has been adopted. The Bank of England will increase its purchases of government bonds and the government will prolong its income support for employees being out of work. Fiscal policy will remain centre stage for many years to come.
The composite PMI saw a big improvement in India, for the second month in a row, and to a lesser degree in the US and China. In these 3 countries, the index is at its highest level of the past 11 months. The euro area countries saw a mixed performance. Significantly better in Ireland, slightly better in Germany but weaker in France, Italy and for the euro area as a whole. There was a big drop in the UK...
Activity was already slowing before the new lockdown measures and the latter will act as an additional brake. We are living in a stop-start economy. The contraction of activity should be more limited than in March-April. The measures are less strict for economic activity, businesses are better prepared and exports should benefit from a more dynamic business environment, in particular in Asia, compared to what happened in spring.The stop-start recovery should also have negative consequences that go beyond the near term. Uncertainty may last for longer which entails increased risk of bigger scars like a rise in long-term unemployment or corporate bankruptcies. It may intensify disinflationary forces and increases the burden on public finances
For a large sample of developed economies, government debt as a percentage of GDP has been on a rising trend over the past 40 years. High public sector debt weakens the resilience of the economy to cope with interest rate and growth shocks. This calls for embarking, at some point in time, on a fiscal consolidation. Clearly, now is not the time. The economy is still recovering from the Covid-19 shock and the outlook remains highly uncertain. Nor is there any urgency, considering the very low interest rates. However, the absence of urgency in the near term should not make us forget about the necessity to act at a later stage. Otherwise, the resilience of the economy would weaken further. It would also represent a bet that in every downturn, central bank QE will come to the rescue.
The Covid-19 pandemic will have profound longer-term consequences. Certain industries will benefit, directly or indirectly, whereas others will suffer.The idea of thriving industries full of new opportunities and others struggling to survive reminds us of Schumpeter’s creative destruction. Such a process can entail huge costs in the short run. Research shows the key role played by active labour market programmes. More broadly, economic policy not only needs to focus on the demand side but also, and increasingly, on the supply side so as to avoid that the pandemic acts as a lasting drag on growth.
A key question in assessing the pace of the recovery in coming quarters is what will happen to corporate investment. Financial analysts are expecting profits of US companies to increase. If confirmed, we can expect better cash flows which, based on historical relationships, should lead, with some delay, to a rise in capital formation by companies. However, there is a possibility that companies which have seen a pandemic-induced rise in indebtedness would prefer to use their extra cash to pay back debt. Cash flow uncertainty is another factor that could weigh on the willingness to invest.
The PMI data for September saw diverging trends, between sectors and geographies. The composite PMI has been stable in the US in September after rebounding the month before. In the euro area however, the jump in July was shortlived and after the sharp drop in August, September saw another decline, leaving the PMI just above the 50 threshold...
In recent decades, the experience in many countries has been that the decline of the public debt ratio during expansions did not compensate for the increase during recessions. This could end up creating concern about sovereign risk and influence the borrowing cost. Under the assumption of permanent reinvestment of maturing paper, significant holdings by the central bank of government paper as a result of quantitative easing, could limit this risk. This depends on the interest rate on excess reserves and on whether such a policy ends up generating higher inflation and/or inflation expectations.
For several weeks now, the improvement in economic data has been slowing down. On the one hand, this loss of momentum is unsurprising as it followed a substantial rebound which could not last. On the other hand, this fall could reflect the economic reaction to the rise in the number of new Covid-19 cases in many countries. Furthermore, the level of uncertainty which remains very high, affecting households and businesses, should also play a role. As a result, monetary and especially fiscal policies remain crucial in ensuring that the recovery continues pending the release of a vaccine.
Declining effectiveness of monetary policy and increased fiscal policy space make the case for increased public debt issuance in combination with quantitative easing to boost growth. There is concern that such policy coordination would lead to fiscal dominance whereby monetary policy is dictated by considerations in terms of public finances to maintain public debt sustainability. Once the pandemic will be behind us, governments will have the responsibility to improve their public finances. Inaction in this respect would put the burden on the ECB when fighting future downturns. It would be a different type of fiscal dominance.
Based on our indicators, uncertainty has declined after the huge jump earlier in the year following the outbreak and spreading of Covid-19. Starting top left and moving clockwise, the media coverage based indicator has declined but remains at a high level, reflecting that the pandemic continues to dominate headlines. Uncertainty based on company surveys has eased in the US whereas in Germany, the improvement is more outspoken. In both cases however, the level remains very high. The geopolitical risk measure has increased recently. The series is quite volatile but one observes a rising trend [...]
Over the past 10 years, fostering inclusive growth has moved higher up the agenda of governments, international institutions and, increasingly, companies. Under Chairman Powell, it has become a key topic for the Federal Reserve through the focus on the heterogeneity of the labour market situation of different socio-economic groups. It has led to the view that pre-emptive tightening based on a declining unemployment rate is unwarranted. On the contrary, it may very well stop people from finding a job. It will be interesting to see whether other central banks and in particular the ECB in the context of its strategy review, will follow in the Fed’s footsteps.
The outcome of the ECB meeting was eagerly awaited considering the latest inflation data, the strengthening of the euro and the Federal Reserve’s new strategy of targeting average inflation. The implicit message from the ECB President’s press conference was “be patient” on the three areas of concern. Inflation is projected to pick up whilst staying well below the target, the euro exchange rate is being closely monitored and the sheer number of strategy review workstreams implies it will take quite some time before we learn about the outcome in terms of the inflation objective.
The Fed’s new inflation averaging strategy should have global real and financial spillover effects. The former refer to international trade whereby a more sustained expansion of US GDP should pull along the economies of its trading partners via increased US imports. The financial spillovers are driven by capital flows, monetary policy and risk appetite. These factors are highly intertwined. The new Fed strategy will also force other central banks to revisit their own strategy. This creates an issue for the ECB.
The Federal Reserve has changed its longer-run goals. Going forward, monetary policy will focus on the shortfall of employment from its maximum level, rather than on the deviations from this level. More importantly, the central bank will now seek to achieve inflation that averages 2 percent over time. The announcement implies a more accommodative stance because the timing of the first rate hike is now pushed further into the future. It also means that, eventually, the Fed’s reaction function will become more difficult to read: when will average inflation –a concept that remains to be defined- warrant a policy tightening? Such ambiguity would then lead to increased volatility, unless guidance takes an even bigger role.
The latest flash PMIs had raised some concern given the weakening of the composite index for the eurozone (from 54.9 to 51.6) and Germany (from 55.3 to 53.7) and an even bigger decline in France (from 57.3 to 51.7).
Unsurprisingly, this week’s GDP numbers for the second quarter were exceptionally bad. The third quarter should see strong quarterly growth, if only because of a powerful base effect. It also leaves room for disappointment however, should the growth momentum start to slip over the summer. In the US, this already seems to have started. In the euro area, business surveys continue to improve and the employment expectations indicator sees a marked increase. Households are not convinced however and their unemployment expectations have remained broadly stable.