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Tempered optimism

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This weekend saw the Jackson Hole meeting of central bankers in the US. Unlike previous meetings, there was an optimistic, if slightly defensive tone. Focus turned from economic recovery to financial stability and central bankers effectively declared they have done all they can and governments must do more.
A key criticism of central bankers has been their inability to create economic growth and thereby inflation, despite holding interest rates at emergency levels for almost nine years. Critics question central bankers’ reliance on the Phillips curve which states there is an inverse relationship between unemployment and inflation. With unemployment at historically low levels in many western economies and inflation targets being continually downgraded, such criticism is easily explained.  The ECB conceded at its July meeting that we could be witnessing a “structural break in the Phillips curve” as a result of changes in labour markets, contracts and wage-negotiating processes stemming from advancements in technology and globalisation.  
However, those trumpeting the death of the Phillips curve should be mindful that it has been widely accepted amongst economists as being ”a substantial body of theory, informed by considerable historical evidence” (Janet Yellen) and they are unlikely to abandon it easily. Furthermore, central bankers are only too aware that the relationship between unemployment and inflation is not necessarily stable, and with certain external shocks can temporarily appear flat or even linearly-correlated as was the case in the 1970s and the 1980s. However, as was the case then and as heralded by Yellen following June’s Fed rate increase, eventually the relationship will hold.
It certainly appears that Yellen is so confident in the Phillips curve that her attention is on orchestrating a gradual increase in interest rates, to proactively manage the eventual increase in inflation rather than risk a sudden and reactionary correction. We witnessed the latter in the 1960s when unemployment was last below 4% and inflation jumped from 1.5% in 1965 to 3.2% within 12 months before eventually hitting 5% by the end of the decade. Therefore, the Fed is likely to announce the reduction in its balance sheet as early as the September meeting, with a likely further increase in rates in December.
Central bankers’ confidence in their chosen strategy could also be evidenced by the minimal attention they dedicated to monetary policy. Instead, they were more concerned with defending the current regulatory environment in the face of growing calls for structural change, including from the White House. Instead of looking to orchestrate yet another overhaul of the financial sector, which is largely well capitalised, at this point of the business cycle governments would do better to implement pro-growth policies to allow the currently low interest rates to be truly effective.
Such policies would be most constructive to the financial sector in allowing artificially low interest rates to ‘normalise’ and thereby take the burden off consumers, who have seen their purchasing power decline and household debts rise. In the UK, such debts as a proportion of incomes have worryingly increased from 130% to 135% over the last 12 months, with consumer credit data on Wednesday likely to show a further increase. Although they remain below the 150% levels of the financial crisis, it should not be overlooked that the insolvency rate rose last year for the first time since 2009. With the pound hitting 1.0750 against the euro, the lowest level in eight years, as the economic fortunes of the two areas appear to be diverging, the pressure on consumers is only likely to grow. The signs are that net trade has not benefited from the depreciation of the pound as expected and has instead been a slight drag on growth.
Of more immediate concern to Theresa May should be the data last week showing flat-lining business investment. Instead of congratulating themselves on reducing migration by a quarter for the year to March, and thereby yet again miserably failing to meet their manifesto pledge, the UK Government should be engaging business leaders who continue to raise their concerns around Brexit and the lack of clarity on key issues. As stressed by attendees at Jackson Hole, the impact of low interest rates is limited unless businesses are availing themselves of them to invest. A return to Brussels for the third round of negotiations this week will provide the Government with a further opportunity for clarity and progress – although the latter appears wishful thinking unless the UK Government is willing to directly address the divorce bill.
Frustration is not solely limited to the UK, with warnings from Jackson Hole of the harm the gridlock in Washington is having as we approach the pending debt ceiling in the US. When Congress returns on 5 September they will have little over three weeks to pass the budget and raise the debt ceiling so as to avoid the treasury being unable to meet its obligations. With the Republican Party controlling both houses this should be a non-issue, and might explain why the markets are as yet relaxed; but as seen with previous legislative failures, there are no easy wins in the current political environment. Once a compromise is made, and it surely will be, attention should rapidly turn to implementing long-overdue pro-growth policies. Commentators will be looking for such signs in Trump’s speech this week when he turns his attention to tax reforms with the aim of securing his first much-needed legislative win by the end of the year.
Whilst the fortunes of the EU appear to be increasingly positive, with the 20-year EUR swap at similar levels to its GBP equivalent, policymakers should be mindful of the low base from which they are starting and the continued need for meaningful reforms. Brexit should not be seen as an excuse for delaying these reforms but as an opportunity. However, given the growing standoff between Macron and the Polish government around his proposed pan-European labour reforms, expect progress to remain unsatisfactorily slow. Look to improving European economic sentiment indicators on Wednesday followed by inflation and unemployment figures on Thursday: the latter are likely to remain unchanged whilst the former is expected to rise to 1.4% for August, having previously been 1.3%.

All views expressed here are the author’s own and are based on information and data available at the time of writing




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