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Will Aggressive Monetary and Fiscal Measures Prevent Stag-deflation in 2009?
RGE Lead Analysts | Dec 12, 2008
Central banks around the world have undertaken a number of measures to forestall deflation and lift the global economy out of economic slump and credit crisis. Aside from traditional monetary policy tools such as official interest rate cuts and relaxations in reserve requirements, central banks have resorted to alternative unconventional tools. Quantitative easing has begun in the epicenters of the credit crisis, U.S. and Europe, who may be joined by other central banks as they too head towards zero interest rates in leaps and bounds (Sweden moved the most in the developed world by 175bp in one shot). With monetary policy transmission broken by the unwillingness of the private sector to lend or borrow, central banks have had to scurry for alternatives to rate cutting in order to restore markets. They set up an alphabet soup of liquidity facilities that lend funds or purchase assets, offered guarantees on deposits and loans, and established currency swap lines, in addition to a host of fiscal stimulus packages announced by governments.
So are the pieces now in place to prevent global stag-deflation? It is too soon to tell. So far, money market and commercial paper markets have shown tentative signs of easing. But elsewhere in the private sector credit market, tensions remain as asset prices move shambolically and de-leveraging drags on among households, banks and businesses. Though money supply has grown, the velocity of money has slowed despite the flood of liquidity from central banks and official interest rates effectively at or near zero. In other words, we have fallen into a liquidity trap. Such a blow to consumer demand makes deflation in 2009 a real possibility.
Leading the global effort against the credit crisis/recession/deflation are the Federal Reserve and the ECB. Since the start of the crisis, the Fed and ECB have cut a cumulative 425bp and 175bp, respectively. Other central banks in both the developing and developed world have been more aggressive in cutting rates but they started from a higher base or began easing late. In addition to rate cuts, the Fed and ECB have used more targeted measures, setting up new liquidity facilities, asset purchasing programs and currency swap lines, as well as bailing out systemically critical firms and broadening the range of collateral and extending the term of funds lent out at special facilities. Several new programs have been added to the Fed's toolbox since the credit crisis began in August 2007, such as TALF, AMLF, MMIFF, CPFF, TSLF, PDCF, TAF. In October, the Fed began paying interest on reserves deposited at the Fed to allow for essentially limitless balance sheet growth. At the same time, the ECB began offering unlimited cash at its weekly auctions. As a result, the Fed and ECB's balance sheets have exploded.
Despite liquidity raining down on the financial system from the Fed and ECB, the financial fires have yet to be extinguished. Yes, money market rates are off their peaks and the commercial paper market contraction has bottomed. But a lack of confidence among lenders in potential borrowers (and a lack of confidence among potential borrowers given the profit or income outlook) and falling asset valuations has stymied significant easing in market interest rates, such as for mortgages and car loans. Rate cuts and quantitative easing notwithstanding, it seems the threat of a liquidity trap is looming on the U.S. (and the EMU). Central banks still have ammo left to shoot their way out of the trap and forestall deflation. One option is debt monetization: inflating away the public debt from sharp fiscal expansion to stimulate the economy. Bernanke recently brought up the option of Federal Reserve purchases of longer-term Treasuries and agency debt. Check out: “Impact of Fed Rate Cuts and Quantitative Easing” and “Operation Twist: Then and Now”
In the U.S., private demand continues to fall sharply as does the string of awful economic and financial news. The latest employment report surprised on the negative side (with the largest payroll decline since 1974) and job losses are bound to keep mounting. U.S. GDP is expected to shrink 4% or more in Q4 2008 and the contraction is expected to continue throughout 2009. Orthodox and unorthodox monetary policy measures are certainly needed but they have to be accompanied by a significant stimulus on the fiscal side to support aggregate demand. The great retrenchment of the private sector balance is already under way and the new U.S. administration is getting ready to make the largest investment in infrastructure of the last 50 years. The details of the size and content of the stimulus package are not available yet. However, there seems to be a general consensus that a package of $300-$400bn dollars is a lower bound to keep the economy moving,.
Let’s make some back of the envelope computations. The depreciation of the U.S. stock of housing goods brings serious negative wealth effects. According to our computations a 30% fall in home prices peak to trough (and U.S. home prices might very well fall more than that) could result in a negative wealth effect that could subtract up to $400-$500bn from private consumption over time. In the same fashion, a painful rebalancing process that would bring to U.S. saving rates back to the levels of a decade ago (around 6%) would be compatible with a decline in consumption of almost $1 trillion.
It is welcome news that the stimulus package will most likely be in the $500-700bn range and that it will target productive investment in infrastructure, public services and green technology. However, a fiscal stimulus will not prevent a severe recession at this point – the U.S. economy is officially already in recession since Q4 2007 – but will make the recession shorter and less severe than it would otherwise have been.
The EU Commission’s ‘recovery plan’ to be adopted during the EU summit on December 11-12 envisages a fiscal stimulus of around 1.5% of EU GDP or €200bn (approx $260bn). Most of the money will be drawn from national budgets, with EU countries asked to contribute €170bn (approx $221bn) or 1.2% of the EU's GDP. The rest – around €30bn (approx $39bn) or 0.3% of GDP – would come from the EU's own budget and the European Investment Bank (EIB). While some large member states such as the UK and France would like to see a larger common effort to maximize the economic impact and reduce cross-border leaks, Germany looks back at 10 years of hard structural adjustment and highlights the need for each country to keep its own house in order. The same dynamic is also blocking a Common European Bond , which was recently rejected by ECB president Trichet.
Commentators point out that even from a purely domestic perspective, a strong fiscal stimulus is exactly the right medicine for Germany that slipped into recession in Q3 alongside its European partners. Compare the different fiscal packages in Germany, France, Italy, Spain, and the UK.
The United Kingdom is experiencing a large-scale slowdown similar or even worse than the U.S. economy with a deep correction in the housing sector and clear signs of contraction in demand. UK's GDP growth will likely slow towards 1% in 2008 and is expected to contract in 2009. Next year consumption and business investment are expected to drop as the impact of the credit crunch deepens. The government is preparing to pump about £39bn (approx $58bn) into three of the country’s largest banks in a broad-based recapitalization that could see the UK government end up with controlling stakes in RBS and HBOS. The government has been taking major steps to inject liquidity into the system, raising the availability of the Special Liquidity Scheme (SLS) to at least £200bn (approx $296bn) and guaranteeing the issuance of short and medium term debt by banks. The Bank of England (BoE) cut the benchmark interest rate 100 bps to 2.0% on December 4th, the lowest since 1951, after unexpectedly slashing rates by 150 bps early in November, in the wake of what was seen by the central bank “the most serious economic disruption for almost a century”. A fiscal stimulus of £20bn (approx $30b or 1% of GDP) was recently unveiled and a new fiscal rule to improve the cyclically-adjusted level of borrowing every year. Borrowing would rise to £78bn ($115bn) this year and then £118bn ($175bn) in 2009-10 with public sector net debt surging above the current limit of 40% of national income this year, reaching 57% by 2013-14. Part of the spending would be found through £5bn ($7.4bn) in efficiency savings in 2010-11while public spending would be squeezed after 2011 when the growth rate of spending after inflation would be cut from 1.9% a year to 1.2% a year. In addition , value-added tax will be cut from December 1 from 17.5% to 15% until the end of 2009, to make goods and services cheaper and encourage growth, in a move that Mr. Darling described as “a measure to help everyone and deliver a much need injection into the economy.”
After some reluctance, Canada too seems to be joining the fiscal stimulus club despite a recent fiscal statement that planned to cut spending and nearly triggered the downfall of the government before a suspension was called till early January. Even without additional spending, lower revenue was already likely to push Canada into a fiscal deficit position, its first in a decade, leading some to worry about a return to an era of structural deficits. Yet with Canada clearly in recessionary territory- despite outgrowing the rest of the G10 in Q3 - a fiscal stimulus seems appropriate to support its faltering domestic demand in the face of deteriorating terms of trade. The Bank of Canada is doing what it can to limit the impact of the recession on the real economy and to meet its primary goal of the 2% core inflation target. It cut interest rates by a higher than expected 75bp yesterday to 1.5%, taking cumulative stimulus to 300bps and is expected to cut a further 50bp at its next meeting in Jan. 2009. It has also continued to inject liquidity through purchase and resale agreements. Yet, Canadian dollar depreciation may limits Canada’s deflationary risk.
Stag-deflation accurately describes where Japan is heading. In Q3, Japan officially entered recession and many analysts do not foresee a recovery in growth until at least 2010. Meanwhile, deflation is rearing its ugly head once again, as detailed in a recent RGE note by Mary Stokes, although there is some disagreement over how short-lived it will be this time around.
So how do policymakers address this dangerous cycle of falling prices and economic stagnation? This is, of course, the big question worldwide. In Japan’s case, the Bank of Japan has almost no firepower left with the benchmark interest rate already at 0.3% (the lowest in the industrialized world). Meanwhile, Japan has two fiscal stimulus packages on the table, but it’s unclear how much of a contribution they will make in getting the economy back on a growth track. Reaching further into the policy option toolbox, some analysts are now discussing a return to quantitative easing and whether such a move would improve Japan’s economic prospects.
Almost all Asia and Pacific central banks have now cut policy rates (Philippines and Pakistan are two exceptions) and used other monetary policy measures to contain the liquidity squeeze in credit markets. With exports and relatively weak domestic demand deteriorating, concerns about significant growth slowdown (and contraction in countries like South Korea, Singapore, Taiwan, Hong Kong) are pushing Asia to join the global trend of loosening monetary policy and providing fiscal stimulus, quite aggressively in some countries now that commodity-led inflation is easing. China and India have been particularly aggressive. Some Asian countries are perhaps less able to engage in aggressive fiscal and monetary stimulus, either because they run fiscal deficits or they continue to have elevated inflation.
China’s monetary easing is well under way. Last week it cut interest rates by 108bps (it always moves in a multiple of 9), the most in 11 years, taking the 1 year lending rate to 5.58% and the deposit rate to 2.52%. It has also reduced the reserve requirement, reduced its sterilization of the monetary supply by cutting the sale of treasury bills and perhaps most significantly removed all lending curbs which had been deployed to counter overheating and inflation earlier this year. China is also beginning to roll out a fiscal stimulus to support growth. Its heralded $586 billion package though repackages other previous spending and it may fail to offset the weakness in the housing and construction sector especially if exports contract. However, approval of previously frozen projects may speed the spending roll out even if it rewards well-connected regions, providing some support for commodity demand. Despite the inclusion of spending on pensions etc, it is uncertain how much Chinese fiscal stimulus and associated tax policy changes like the introduction of a value added tax will succeed in rebalancing growth away from investment.
Last week India announced a $4bn fiscal package including 200 bn rupees in additional spending, a value-added tax cut export credits for textile, leather and jewelry sectors and sales tax refunds as well as tax-free bonds for infrastructure. However, it may come at the cost of increasing India’s fiscal deficit. The RBI has lowered the repo rate 250 bps since October, made the first cuts in the reverse repo rate since 2003 and eased credit and conditions for restructuring loans directed towards SMEs, corporate sector and housing sector. Both India and China are planning fuel price reductions which may provide some boost to consumers while still providing profit margins for refiners.
The swift decline in the price of crude oil – now well below the break even point for most oil exporting economies – may lead to some reduction in spending or a slowing trajectory of spending growth in 2009. GCC countries, as well as Libya and Algeria may be best placed to maintain current spending patterns or substitute for private flows, given their accumulated savings even if some of these stockpiles have shrunk along with global equities. Countries like Nigeria, Venezuela, Iran and Russia – may be less able to do so and could see sharp declines in growth, particularly with further oil production cuts in the works. GCC countries have also been easing monetary policy (along with the Fed) and using a range of tools to inject liquidity in the face of elevated interbank rates. Yet, monetary and fiscal measures may only go so far in supporting growth as both hydrocarbon and non-hydrocarbon output is likely to slow sharply. Meanwhile other MENA countries seem to be in a position to provide countercyclical fiscal policy.
Russian policy makers have been quick, if not necessarily always coordinated, in their response to slowing growth and sharp capital outflows. Russian PM Putin recently suggested additional fiscal stimulus measures including cuts in corporate taxes, a hike in unemployment benefits and pensions as well as more defense and construction spending. By some accounts, these measures take Russian government spending on economic and financial stabilization to as much as $400 billion or 25% of GDP and may take the budget deficit to well over 2% of GDP next year. With inflation still elevated and policy rates continuing to be very negative in real terms, few monetary measures are available, particularly as Russia has increased interest rates to discourage deposit outflows. With Russia’s terms of trade eroding – the current account could shift into deficit as soon as this quarter, and domestic demand beginning to falter, growth could slow very sharply from the 6.2% it marked in Q308 and a contraction is not out of the question in 2009 if oil prices remain at current levels, as detailed in recent notes by Nouriel Roubini and Rachel Ziemba. Russian attempts to allow only slow depreciation of the rouble contributed to the loss of 25% of its $600 billion in foreign exchange reserves since August and outflows from the domestic banking system – a depletion that led S&P to downgrade the country to BBB on Monday. Russia may need to follow the Ukrainian example and allow a sharper devaluation.
What economic worries might be keeping Eastern European policymakers up at night? Right now, stagnation – rather than stag-deflation – seems to be the pressing concern. Economic growth rates in Central Europe are slowing, though the sharpness of the slowdowns has varied.
Hungary – the economic laggard of the group, which was forced to turn to the IMF and EU for a $25 billion rescue package in late October – is seen contracting in 2009. Meanwhile, Poland, the Czech Republic and Slovakia are expected to experience positive, albeit sluggish growth.
Easing inflation has given central banks in Central Europe room to maneuver, enabling them to start cutting rates to give their slowing economies a boost. Going forward, analysts see more rate cuts in the pipeline. Nevertheless, monetary policy easing is limited in countries with heavy foreign currency-denominated lending, like Hungary or Romania, where a weakening local currency could potentially trigger defaults, thereby impacting financial stability.
As for fiscal policy, Central European policymakers may be reticent to undertake expansive stimulus packages as such moves could further weigh on their current-account deficits and undermine investor confidence. And in stark contrast to expansionary fiscal policy elsewhere, Hungary is engaging in fiscal tightening in conjunction with its IMF agreement.
Exceptions to the rule? Unlike Central Europe’s slowing economies, the so-called gravity defiers Bulgaria and Romania continued to post envy-inducing growth rates of 7.1% and 9.3% in Q2. Nevertheless, these growth rates seem unsustainable given the accompanying imbalances – double-digit current-account deficits and high inflation. Consequently, this could be a case of ‘the higher they rise, the harder they fall’ where Bulgaria and Romania not only experience slower growth like much of Central Europe, but could potentially face economic crises.
The Baltic states – the sick men of Eastern Europe – are dealing with a particularly nasty case of stagflation. Latvia and Estonia are now officially in recessions, and Lithuania could soon join them. When it comes to options for dealing with the painful economic adjustments in progress, Baltic policymakers’ hands are tied. That’s because all of them have fixed exchange rates to the euro and therefore no independent monetary policy. Meanwhile, Baltic governments’ ability to loosen fiscal policy to support growth is limited by massive imbalances.
Among the Latin American countries, the prospects of a slowdown are also widespread, although the intensity of the deceleration and the seriousness of the crises is in many ways distinct within the region. Mexico is definitely on the top of the list of those most affected by the global slowdown with trade flows largely dependent on the U.S. economy but should also be seen at the front line of the region’s defense against the contraction. Despite the challenging credit crunch and the sharp fall in oil prices, which put a dent in fiscal revenues, Mexico has a much better fiscal situation to deal with a US recession compared to previous episodes. The government has approved a budget for 2009 in which fiscal spending is set to grow by 5% and, to stimulate the economy, the government plans to spend an incremental US$7.3bn or 0.7% of GDP in 2009, 72% of which is earmarked for higher infrastructure spending, thus running a consolidated public sector deficit next year for the first time since 2005. In Brazil, a provisional measure bill eased constrains for two public banks to acquire capital of private financial institutions. It also creates an investment bank to acquire capital not just in the financial, but other sectors as well. The BCB also put in place currency swap lines with other international central banks, in a similar way as the Central bank of Mexico. The Chilean government is a very good example of prudent fiscal conduct and the government has now enough ammunition to act counter-cyclically despite the sharp fall in copper prices and tax revenues from a fading economy. In Peru, the government recently announced it will spend as much as USD 3.2bn next year on infrastructural projects to bolster economic growth. Going into the more extreme cases, we should mention that Ecuador is considering a default on its external debt and the market is also worried about Argentina and Venezuela.