Just when the clouds seemed to be lifting, the global economy has been hit by more economic and financial shocks, as seen in the rippling effects of China’s market plunge in recent days.
Several economies are facing a downturn or are slowing. Consensus forecasts for 2015 in large economies are not predicting real gross domestic product growth rates in the world’s largest economies above 2 per cent, except in the United States and Britain. Inflation remains low, although it is forecast to rise in the large economies – a reflection, perhaps, of forecasters’ belief that economic performance will improve. Only Switzerland (not even Japan) is expected to suffer from deflation. Unfortunately, recent experience also suggests that one-year-ahead growth forecasts have often proved optimistic, while inflation forecasts have on occasion been overly pessimistic.
Despite years of quantitative easing and ultra-low interest rates, the global economy has not been able to reach “escape velocity.” For example, in the United States, the current expansion (which dates from June, 2009, according to the U.S. National Bureau of Economic Research) is now the fifth longest on record – slow and steady growth. However, if the past is any guide, policy-makers will undoubtedly have to worry about the next slowdown or downturn to come, with an economy not yet back to full capacity. Simultaneously, however, the Fed has been trying to prepare the public for another escape, this time from the so-called “zero lower bound.”
There are convincing reasons to believe that low interest rates, combined with the stimulative quantitative easing introduced in economies most directly implicated by the global financial crisis of 2008-09, cushioned the world economy against a far worse outcome. As we approach the seventh anniversary of the Lehman bankruptcy, we have indications that another moment has arrived, with China’s economy slowing and the authorities unable to stem sharp declines in stock prices.
The economic slowdown of China has been a long time coming and market observers were aware that the rise in stock prices was unsustainable, much like a previous stock market correction in 2007. Nevertheless, an accumulation of seemingly unrelated events, including the handling of the Tianjin explosions (to give just one example), may well have brought about a tipping point that also lays bare the economic challenges facing the Chinese authorities.
My own research suggests that shocks from the United States, both of the economic and financial variety, have a greater impact on China than the other way around. Moreover, China has been loosening its monetary policy for some time now. The recent devaluation of the yuan is arguably the least significant among other forms of policy easing that have taken place, including a reduction in interest rates, a relaxation of reserve requirements and (ineffective) support of the stock market.
Markets seem to have come to understand that while China and the rest of the world economy are coupled to a degree, the future capacity to fight the elephant that remains in the room – namely, too much debt – may no longer be adequate. Sizable foreign exchange reserves, among other policy tools available to the Chinese government, are likely sufficient to prevent a full-blown crisis from taking place for now, but it is unclear for how long or with what degree of effectiveness the authorities will be able to continue doing so.
Back in the United States, the accumulated effects of low interest rates may well be starting to extract a toll on the economy. Of course, many observers will argue that inflation continues to remain low, indeed below target in several economies, and growth anemic. Hence, it is a mistake to raise rates now. In Canada, for example, headline inflation has fluctuated around the 2-per-cent target, albeit with persistent departures from the target, in part because of large swings in commodity prices. Expectations also seem to be firmly anchored around the target. As a result, real interest rates – that is, interest rates adjusted for observed or expected inflation – have been very low, if not negative, depending on the financial asset in question.
This is a phenomenon repeated in the rest of the industrial world and is appropriate, for example, when economies are contracting. Nevertheless, after almost eight years, there is a price to be paid for such policies. In particular, if low or negative rates of return are necessary for some to restore balance sheets or ease the debt burden as deleveraging takes place, they are not appropriate for others or even in general for an extended period of time. History has also shown us that a reluctance to raise interest rates (the previous occurrence was in an environment of higher inflation) simply delayed the inevitable, and economically painful, policy tightening later.
Central banks have been fond of explaining their decisions as being “data dependent,” but we still expect the monetary authorities to make sense of conflicting data and provide some clarity. Fearful of making a mistake, central banks (including the Bank of Canada) have changed course, in some cases reversing previously unwarranted or poorly explained interest rate increases or expressions of the need to tighten policy rates soon. This has likely hurt their credibility in ways not easily captured by looking at selected inflation forecasts. An opportunity to explain that there is a cost to maintaining low interest rates, and that other tools exist to soften a return to more normal levels, has been lost.
Indeed, the story, whether it is China, the United States or even Canada, is that current monetary policies cannot and will not prevent financial instability. In this sense, what is happening in China, while partly homegrown, is a symptom of policies that have run their course.