William De Vijlder

Group Chief Economist BNP Paribas

ECB: reviewing strategy whilst waiting for inflation

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Import Export

The US-China trade: few reasons to be cheerful

The US-China trade deal has brought relief. It avoids new tariff increases by the US with the risk of further escalation. The deal should be welcomed in China, given its ongoing growth slowdown, but also in the US where companies had increasingly expressed their concern about the trade confrontation. The rest of the world will monitor closely the extent of trade diversion which could follow from the agreement. Attention will now shift to the phase 2 negotiations, which could very well mean that trade uncertainty will intensify at some stage.

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Question marks

Markets and geopolitical uncertainty: (ir)rational complacency?

There is a considerable gap between what are considered to be the geopolitical ramifications of the escalating tensions between the US and Iran since the start of the year and the subdued reaction of markets. The market reaction probably reflects the investors’ view that the probability-weighted impact on growth should be very limited because the risk of a major escalation is considered to be small and/or because of an expectation that the impact of higher oil prices on the economy is limited. What also may play a role in the market reaction thus far is that, leaving the geopolitical uncertainty aside, the economic environment is considered to be conducive to taking risk: stabilisation of survey data, reduction in trade-related uncertainty and accommodative monetary policy.

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Economie mondiale

2019: a difficult year, ending on a hopeful note

2019 has been dominated by uncertainty, in particular about trade tensions and hard Brexit risk, as well as mounting concern about the slowdown of the global economy. This has led to additional policy easing by the ECB whereas the Federal Reserve has reversed course by cutting the federal funds rate on several occasions. This has further reduced the remaining policy leeway of central banks, a subject that will be analysed in the context of the strategic reviews by the Fed and the ECB. It has also led to increased calls for fiscal stimulus. Equity markets have delivered surprisingly strong returns with investors preferring to look at the role of lower interest rates, rather than at the weakening of the profits outlook. The year ended on a hopeful note with the improvement of certain business surveys.

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Zone euro

Eurozone: very low interest rates for how long?

Danish monetary policy is closely linked to ECB policy so the recent statement of Denmark’s central bank governor that he expects interest rates to remain around current negative levels in the next five to ten years is not without importance for the Eurozone. Forward guidance by ECB implies that policy will only be adjusted when justified by economic conditions. The inability to be clearer in terms of time frame illustrates the complexities of inflation dynamics. Past wage increases will gradually filter through in a pick-up in inflation although low inflation, well-anchored inflation expectations and intense competition in certain sectors may very well moderate this transmission. It thus seems clear that the current policy will remain in place for a considerable time. How long ’considerable’ turns out to be will depend on the data. The eurozone clearly needs more growth.

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Global economy

Global economy: stabilisation, stability, opacity

Based on business surveys, the cyclical environment, globally, seems to have stabilised. A similar picture emerges for the eurozone and China, whereas in the US it is mixed. ‘Stability’ characterises the monetary policy outlook. After the announcements in September, the ECB can afford to wait before making a judgment of the effectiveness of its policy stance. For the Federal Reserve, it seems that the bar for envisaging a change in the federal funds rate is high, even more so when it’s about considering a rate hike. Stabilisation of economic data and a stable, very accommodative monetary stance provide reasons for being hopeful, but this supposes that uncertainty doesn’t increase again. In this respect, unfortunately, the situation remains very opaque. Shifting to a higher gear in terms of growth then becomes more complex.

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Eurozone

Eurozone: QE and market instability risks

The ECB’s monetary policy meeting account illustrates the dilemma it is facing: inflation is subdued and risks to growth are tilted to the downside, yet the financial stability implications of the very accommodative policy need to be closely monitored. These implications are covered in sobering detail in the ECB’s Financial Stability Review. A possible side effect of very low to negative interest rates is that borrowing and spending become more procyclical. Quantitative easing (QE), by modifying the risk structure of investment portfolios (less government bonds and more exposure to assets with a higher risk), will probably increase the sensitivity of portfolio returns to the business cycle.

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Eurozone

Eurozone: which role for automatic fiscal stabilisers?

Automatic fiscal stabilisers help cushion the impact of economic shocks on GDP via changes in government revenues (because of progressive taxes) and expenditures (unemployment insurance). The limited remaining monetary policy leeway in the eurozone is fueling interest in the effectiveness of the automatic stabilisers. European Commission research confirms that, to some degree, automatic stabilisers iron out the impact of negative shocks on GDP. Whether that is enough is another matter. It warrants a debate on the role of discretionary fiscal policy in case of a recession.

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Financial Markets

What drives the recent rise in bond yields and equity markets?

In recent weeks, equity markets performed well. Focussing on the US, it is hard to argue that this reflects an improvement in the earnings outlook or a perspective of more rate cuts than hitherto expected. This would imply that a decline in the required risk premium was the key driver. US treasury yields also increased significantly, which probably reflects to a large degree an increase in the term premium. The decline in the equity risk premium and the increase in the bond term premium were driven by a common factor, namely a reduction in economic tail risk on the back of progress in the trade negotiations between the US and China and a stabilisation of certain survey data.
The reduced likelihood of very negative economic developments, which has boosted equity markets, has also reduced the attraction of bonds as a hedge against equity risk. As a consequence, bond yields have moved up in sync with equity markets.

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Stability

Business sentiment stabilises, but at a low level

Recent business surveys such as the purchasing managers’ indices, point towards a broad-based stabilisation in October. This is a welcome development after a prolonged downward trend. However, in a historical perspective, the recent readings are low or, looking at the manufacturing sector, very low. This points to an ongoing subdued growth environment. Going forward, a sideways movement of these surveys should increase the likelihood of a growth acceleration: when the frequency of bad news drops, confidence should eventually rebound, fuelling spending, all the more so given the very accommodative financial and monetary conditions.

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Halloween, fear and the economy

Do fluctuations in uncertainty have a symmetric or asymmetric effect on the economy? The question is important considering that since last year, uncertainty has been acting as a headwind to global growth. Moreover, recent news about the US-China trade negotiations and Brexit have raised hope that uncertainty may have peaked and that growth in activity could accelerate. Empirical research shows that an increase in uncertainty has a bigger effect on the economy than a decline, in particular in a subdued growth environment. This would suggest that, should the decline in uncertainty be confirmed, the pick-up in growth would be very gradual.

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question mark

Uncertainty: peaking or just migrating?

The US-China trade conflict and Brexit have been acting as a headwind for growth for a considerable time now. Recent developments have raised expectations that these sources of uncertainty may have peaked. Should it turn out to be the case, this could spur spending by unleashing pent-up demand by companies or households. However, in an environment of slowing global growth and, quoting the IMF, a precarious outlook for next year, we probably will see a more limited reaction, with other sources of concern taking over from the previous ones: uncertainty make have peaked in certain areas, but is likely to migrate to other

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IMF

IMF: idiosyncratic recoveries to drive modest growth pick-up

According to the IMF’s chief economist, the growth outlook is precarious. Although the Fund expects somewhat of a pick-up of growth next year, this is driven by a small group of emerging and developing economies which are currently under stress or underperforming. The modest growth acceleration reflects country-specific factors, rather than the expectation of a broad-based improvement. In the US, the growth slowdown is expected to continue well beyond 2020 and Chinese growth is projected to decline to 5.8% next year. Against this background, the projected slight pick-up in the eurozone, driven by Germany and Italy, and which supposes that external demand regains some momentum, looks challenging.

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Japon Mont Fuji

Japan: moving to yield curve slope control?

The Japanese government bond yield curve has been flattening in recent months, with very long maturities coming dangerously close to 0%. This is creating concerns amongst institutional investors with long-dated liabilities (insurance companies, pension funds). Bank of Japan Governor Kuroda has argued that an excessive decline in super-long-term interest rates could negatively impact economic activity
This has raised expectations that the central bank could shift to a policy of controlling the slope as well as the level of the yield curve. This could influence bond yields abroad. In the eurozone it would intensify the debate about the impact of ECB policy on pension funds and insurers.

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GDP

Global growth slowdown intensifies

The slowdown of global growth has gathered pace, forcing the Federal Reserve to cut the federal funds rate on two occasions, whereas the ECB has announced a comprehensive easing package. Nevertheless, the slowdown is expected to continue. Uncertainty is pervasive. Companies question the true state of demand faced with slower growth, trade disputes, Brexit worries, geopolitical risk. Corporate investment suffers and may impact households via slower employment growth. The room to boost growth via monetary policy and, in many countries, fiscal policy has become limited, and this is another factor which could weigh on confidence. Surveys of US corporate executives point towards high concern about recession risk and the US yield curve inversion adds to the unease. However, the picture provided by a broad range of leading indicators is, at least for the time being, less bleak.

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Compass

US: from big growth scare to relief

The manufacturing purchasing managers’ index of the Institute for Supply Management (ISM) has continued its decline in September, reaching 47.8%. The non-manufacturing ISM has registered a big drop of 3.8 percentage points and is now at 52.6% — a very low print for a non-recessionary period. Against this background, bond yields have declined significantly reflecting increasing worries about recession risk, rising expectations about additional Fed easing and a greater flight to safe havens. The labour market data for September however brought some relief. Nevertheless, we expect the Fed to continue to cut rates. US ISM manufacturing and non-manufacturing indices have both declined lately. In this context, the bond yields decline has intensified the fear of a recession. However, the good figures of the labour market data provided some relief.

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Berlin Government district

Germany: fiscal stimulus, hope versus reality

Germany is probably in a technical recession and recent data do not point to any improvement in the near term, quite to the contrary. Given the country’s considerable budget surplus, German business leaders are calling for fiscal stimulus. This echoes Mario Draghi’s plea in favour of budgetary expansion in countries with fiscal space. Simulations show that spillover effects to other eurozone countries would be small. Moreover, the implementation of a fiscal package requires long preparation and may be hampered by labour shortages.

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Decision

Fed and ECB: diverging approaches to monetary policy

The Federal Reserve and the ECB are in very different positions: the former has more room to ease policy and it is also closer to its policy targets. The ECB has limited remaining policy leeway but is confronted with an inflation shortfall versus its aim and a risk that this gap would increase, rather than narrow. These differences have led to diverging approaches in the conduct of and communication about monetary policy. The Fed is data-dependent and, except for the projections of the FOMC members, offers no guidance. The ECB is agnostic about the data and builds its communication around state-dependent forward guidance: policy tightening will be solely conditioned by meeting its target. The ECB stance reduces the sensitivity of financial markets to data surprises whereas the Fed stance increases it. This implies a risk of higher volatility in the US but also, via international spillovers, abroad.

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ECB

ECB: Mario Draghi passes the baton

Market expectations were elevated but the Governing Council did not disappoint. The comprehensive nature of the package, with the introduction of state-dependent forward guidance, take away the need to envisage additional measures in the foreseeable future. ECB watching has been narrowed to monitoring the gap between inflation and the ECB target. Given certain negative side effects of the current monetary mix, which are acknowledged by the Governing Council, fiscal policy, where leeway is available, is now requested to step up to the plate, so as to foster growth and speed up convergence of inflation to target. The policy baton has been passed

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Interrogations

Elevated uncertainty slows growth despite lower rates

Business surveys in the US paint a diverging picture: manufacturing is worsening significantly but services have picked up nicely. Taking a broader perspective, evidence is building of a slowing economy. Less dynamic growth can be observed in engines of growth of the world economy: China and India, although reasons differ. In Europe, Germany is probably already in a technical recession whereas France is resilient. Central banks are back in easing mode but the effectiveness will be hampered by elevated uncertainty, despite the announcement of a new round of trade negotiations between the US and China.

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William De Vijlder

About William De Vijlder

Group Chief
Economist
BNP Paribas
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