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Economic Outlook: Finding Neutral

In his latest outlook, Neil Williams, Senior Economic Adviser to Hermes Investment Management, argues that 10 years after the US and UK took policy-rates down to the floor, major economies have more than recouped their GDP (chart 1). However, these recoveries, are puffed up by cheap money and a $15trn sink of QE which has left them looking so mature that, in market terms, they are starting to ‘smell a bit’, as their longevity is rightly questioned.

Mature recoveries are smelling a bit…

Despite central banks’ previous ‘muscle flexing’, the road to ‘normal’, as gauged by historical standards, is likely to be cut off. We expect another two years of negative real rates in the UK, Japan, and eurozone, while they return only temporarily to positive in the US.

The background frustration is that recoveries have been largely output driven, and are yet to generate enough inflation to trigger the usual reaction-functions (chart 2). The one main economy that has delivered inflation is the UK, but this looks to be more a symptom of the pound’s fall since 2007. Only Italy’s GDP/CPI trade-off has been worse.

It is in the more long-rate sensitive US and eurozone where the growth-risk from QT is probably most acute. In Japan, reliance spanning 20 years potentially precludes QE from ever being switched off. Meanwhile China is stimulating to keep a head on its 6%yoy growth rate, wary of its own slowdown, and of the fact that US tariffs will probably accelerate later in the year.

Where is neutral?

We take our ‘Policy Looseness Analysis’ to the next level, to gauge: how far from historical norms true US and UK peak rates will lie; how appropriate they’ll be for the economy; and how much extra stimulus-withdrawal may thus - in principle - be needed. To reach overall policy ‘neutrality’, other levers would have to be pulled.

The full analysis is on pages 3 and 6 of the report, and offers the following conclusions. First, in the US, falling short of historic rate-norms and, yet, still securing overall policy neutrality, requires the equivalent of about 370bp of extra policy tightening from somewhere. This could come, for example, from exhausting the Fed’s balance sheet and/or fiscal correction.

Secondly, the latter looks unlikely into the 2020 Presidential Election, while the former - at the current pace ($600bn per year) - would take us to the next one! The US is thus approaching its twelfth year of relatively loose policy.

Third, the UK authorities would need 230bp of extra policy tightening to secure overall neutrality. A faster fiscal tightening looks unlikely given the background of Brexit uncertainty which could last years. Neutrality could still be achieved over time by winding down about £300bn of the BoE’s QE-bought bonds, therefore returning the Banks’ balance sheet to its pre-crisis level.  However, for this to happen, it would first require Mr Carney to soften his 15% rule.

Therefore, while the road to ‘normal’ looks closed off in interest-rate terms, overall neutrality can - in principle - still be achieved by pulling more aggressively on the other levers. The practical hurdles, such as current central bank thinking, growth and political risks, suggest the gaps will stay open, leaving policy loose for much longer yet.

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