Monetary policy, good or evil?

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Macro USA

Di Bruno Cavalier, Chief Economist Oddo Group

Worst-case scenarios have been averted in recent months – yet again, we would be tempted to say. The oil price has not fallen to $ 20, China is still standing, the dollar has stabilised and Brexit is no longer causing many jitters. Instead of these much feared catastrophes, global manufacturing activity is shuddering back to life, downward pressures on inflation are diminishing, the US has the most powerful job machine in the world and the Eurozone has survived all sorts of torture instruments (bank stress tests, terrorism and rampant euroscepticism)… Are there still reasons to be worried?

The global economy was not far from capsizing at the end of 2015 when its annualised growth rate fell to around 2.5% and dark clouds hovered on the horizon: a meltdown in the oil market, a soft patch in China and overhasty monetary policy tightening in the US by the Fed. Six months later, growth has risen back towards 3% and the sky is much clearer. The stabilisation of the oil market has had the major consequence of easing pressure on activity and prices in the manufacturing sector, especially in China. This has removed one of the factors that could trigger a recession or deflation. Another has been eliminated by the stabilisation of the dollar, whose sharp appreciation in 2014-2015 had two harmful consequences: it eroded the earnings of US companies and tightened monetary conditions in countries with dollar-denominated debt. In contrast, we expect a slightly weaker dollar to spur the recovery in capital expenditure in the US and to boost activity in emerging countries.

The US economy is within touching distance of the Fed’s targets: an unemployment rate of 5% and an inflation rate of 2%. In truth, these targets have been in sight for some time already, but the Fed Chair Janet Yellen chose not to acknowledge this until very recently. After a first rate hike in December 2015, another is expected to follow before the end of the year. However, with a monetary policy that has only just exited the liquidity trap, the Fed has an asymmetric view of inflation risk. It will not be truly comfortable with monetary normalisation until inflation has exceeded its target, which will not be the case for another few months. We forecast only two interest-rate increases in 2017.

The Eurozone economy is not at the same stage of the business cycle as the US. At the current pace of job creations, full employment is still several years away, as has a return of inflation to the ECB’s target. It is noteworthy that the bank lending recovery continues to gain traction. The ECB is maintaining an accommodative bias (extension of QE), probably because of concerns about a possible “taper tantrum”. A deflation scenario is no longer a tangible threat..

Brexit is a structural shock, not a cyclical one. It is a political shock, not a financial one. It is a localised shock, not a global one. Although the immediate effects are close to nil two months after the event (aside from the steep depreciation of sterling), there is no reason for Brexit to be painless. The policy mix was loosened immediately to mitigate the expected weakening of UK growth. Over the coming year, the repercussions of Brexit will be negative but modest on the European continent and close to nil elsewhere.

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