The Federal Reserve versus the markets: who has it wrong?
Central bank optimism about the global economy stands in contrast to investor outlook
The message sent by investors in stormy financial markets is clear: the global economic expansion could be in trouble. But the Federal Reserve remains optimistic, publishing strong growth forecasts for the US and plotting out more interest rate rises.
So are investors right to be worried? World output growth for this year was projected at a healthy 3.7 per cent by the IMF in October, but the fund’s outgoing chief economist Maurice Obstfeld acknowledged more recently that there is now “some air coming out of the balloon”.
Five advanced economies — Japan, Germany, Italy, Sweden and Switzerland — all experienced contractions in the third quarter of this year.
While the declines were spurred in part by one-off factors, including more stringent car emissions standards in Europe, together the economies affected represent a hefty 15 per cent of world gross domestic product, according to Oxford Economics.
Many economists expect stronger growth in the fourth quarter, but worries remain significant enough for Mario Draghi, the president of the European Central Bank, to speak of “downside risks” to the eurozone at this month’s monetary policy meeting.
Leading indicators have turned downwards, with the OECD this month noting “easing momentum” across Europe, Canada and now the US.
Growth could be set to slow simultaneously in the US, China, Europe and Japan next year compared with this year.
In the US, where the economy is on course for a 3 per cent expansion in 2018, corporate executives are getting nervous.
A total of 48.6 per cent of US chief financial officers surveyed by Duke University now believe the US will be in recession by the end of 2019, and 82 per cent think a recession will have started by the end of 2020.
Erik Nielsen, chief economist at Italy’s UniCredit bank, said he was picking up signs of anxiety in Europe as well, as global trade tensions damaged companies’ willingness to invest. “I worry more and more every day,” he said.
According to data compiled by UniCredit, global trade has slowed sharply, down to 2.25 per cent growth compared with a long-term average of 4.5 per cent.
Mr Nielsen is particularly concerned by the slowdown in China, where retail sales grew at the slowest pace in 15 years in November and factory output was the weakest in nearly three years.
A renewed escalation of the trade battles between the US and Beijing would do further damage to growth and investment in China and elsewhere.
The IMF estimates that, if all of the tariffs threatened to date were actually imposed, as much as three-quarters of 1 per cent of global GDP would be lost by 2020.
“The uncertainties have reduced investment pace,” said Laurence Boone, chief economist at the OECD. “This transition is also coming at a time of political risks in many countries and at a time when the normalisation of US monetary policy is starting to have more significant impact.”
Whether the declining confidence in markets accelerates, feeding into economic outcomes, will depend in part on how deftly central banks respond.
Stephen King, economic adviser to HSBC, noted that the Fed was “not great at delivering soft landings” in the US economy. “Things have a habit of going wrong, particularly when the economic cycle looks relatively mature,” he said.
The Fed has lifted rates nine times in three years, and is set on a balance sheet reduction programme that will contract its asset holdings by hundreds of billions of dollars next year.
This will combine with a waning US fiscal stimulus in the second half of next year. Mark Zandi of Moody’s Analytics expects the stimulus from US tax cuts and public spending increases to have evaporated entirely by 2020.
But US inflation is quiescent despite unemployment hovering at half-century lows, meaning that the Fed can afford to be patient with policy — and that is a message the central bank is likely to hammer home in the coming weeks.
The US outlook also remains healthy overall, with the Atlanta Fed’s tracking estimate for fourth-quarter GDP hovering at 2.7 per cent, compared with 3.4 per cent growth in the third quarter.
While Fed policymakers are projecting slower growth in 2019 than this year, their latest median projection is for 2.3 per cent growth next year, stronger than the economy’s longer-term trend.
Unemployment could carry on falling, if they are right, to bottom out at just 3.5 per cent, down from 3.7 per cent now and the lowest in half a century.
Nevertheless, after the US central bank’s most recent meeting, John Williams, New York Fed chief, emphasised that the country’s policymakers were taking the market sell-off and threat of a global slowdown seriously.
The Fed could slow down or pause its rate-raising cycle early next year. In fact, some economists reckon that the cycle may now be close to its end. If the Fed turns dovish on monetary policy, some of the clouds in global markets could quickly start to lift.