Global: The Great Monetary Easing of 2008

Central banks’ dilemma: ‘stag’ versus ‘flation.’ I continue to expect the global macro environment in 2008 to be characterized by an unpleasant mix of relative economic stagnation in the developed countries and continuing global inflation pressures (see The Stagflation Threat, 9 November 2007). This stagflationary environment creates a dilemma for central banks. If they play tough on inflation, stagnation may turn into a full-blown recession. If they decide to stimulate the economy, inflationary pressures may intensify. Central bankers are acutely aware of this dilemma, which explains why many have been reluctant to ease monetary policy so far. However, more signs of economic slowdown or even recession in early 2008 are likely to swing the balance towards more aggressive monetary easing in the advanced economies. Thus, I expect 2008 to mark the beginning of another global liquidity cycle that is likely to lift most boats again in the following years.

Current problems have monetary roots. Today’s problems can be traced back to overly expansionary monetary policies in the first half of this decade, when the Fed, the ECB and the Bank of Japan kept rates at unusually low levels for extended periods of time. Zero or negative real short-term interest rates, combined with very low long-term interest rates, encouraged excessive risk-taking and myopic behaviour amongst lenders and borrowers, and thus helped pump up the credit bubble that is now bursting. And just as easy credit supported consumer and capital spending then, tight credit conditions will now dampen domestic demand in the US and Europe. Moreover, easy money in the first half of this decade, with a long time lag, created the global inflationary pressures that are now playing out and are likely to persist, especially as monetary conditions in many emerging economies are still expansionary.

Into the ‘stag.’ Economic growth in the advanced economies is likely to slow sharply in 2008. Our US economists even expect two quarters of negative GDP growth in the first half of 2008, followed by a sub-par recovery in the second half (please see Recession Coming, by Dick Berner and David Greenlaw, in this issue). Similarly, our Japan economists expect a mild recession and have slashed their full-year 2008 GDP forecast to only 0.9%. Our European and UK economists look for sub-par growth in the next several quarters, too, with full-year 2008 growth at 1.6% in the euro area and 1.8% in the UK and thus significantly lower than in the last couple of years. For more colour and detail, see their articles in this issue. Emerging economies, where growth is still strong, are likely to be affected by the slowdown in the advanced economies but have significant room for monetary and fiscal stimulus and are less exposed to the credit crunch in the developed world, which should make any slowdown much less severe.

A new inflation regime. The much more controversial part of my stagflation call is the ‘flation’ part. Typically, a slowdown of growth that creates additional slack in the economy should be disinflationary. However, there are two important caveats. First, empirically, the link between ‘slack’ — measured by the output gap or the deviation of unemployment from its natural rate — is fairly weak. For example, estimates by my colleague Manoj Pradhan suggest that over the past two decades, a one percentage point increase in the output gap has reduced inflation by only one-tenth of a percentage point. Second, global factors have become more important in explaining the ups and downs of national inflation rates, especially over the last 10 years, when globalization accelerated. Globalization was disinflationary for many years. More recently, however, globalization has turned into an inflationary force, due to expansionary monetary policies in the emerging world, which have fuelled strong overall demand growth and, specifically, demand for energy and food. Rising energy and food prices have also pushed total inflation higher in the advanced economies, which has started to translate into higher inflation expectations. As I see it, the ‘low’ inflation regime of the past decade is now giving way to a ‘medium-size’ inflation regime in the advanced economies more akin to the one prevailing in the early to mid-nineties. Cyclical factors, such as a sharp economic slowdown, may still temporarily dampen inflation, but the underlying inflation trend should be higher. In theory, of course, central banks have the wherewithal to keep inflation low. However, it would require much higher real interest rates than in the past ‘low’ inflation regime. In an environment of weak growth as we envisage it in 2008, I strongly doubt central banks would tighten the screws.

The Great Monetary Easing of 2008. Right now, most central banks in the advanced economies are still reluctant to ease, given still-strong growth and rising inflation pressures. Only the Fed, the Bank of England and the Bank of Canada have cut rates so far. But with weaker growth or even a mild recession ahead, I expect more central banks to reverse course and join these three in cutting official rates in 2008. Lower rates in the advanced economies will also ease monetary conditions in those emerging economies that have their currencies tied to the dollar or the euro. With monetary easing spilling over from the advanced economies to the emerging world, and a further rise in inflationary pressures. In the meantime, buckle up for a stagflationary 2008.

By Joachim Fels London
Morgan Stanley
December 14, 2007