Contingency thinking for the next downturn

After a dreadful end to the year global equity markets got off to a flying start in 2019. The US S&P 500 index is up by 10% so far this year, having fallen by 16% in the first three weeks of December.

The switch from gloom to cheer reflects a major policy shift by the US Federal Reserve (the Fed).

Last autumn markets were braced for the Fed to carry on raising rates through 2019, even though rates had already risen from 0.25% to 2.5% since late 2015. The Fed was in hawkish mode and way ahead of other central banks in tightening monetary policy.

That hawkishness coupled with signs of a weakening in global and, increasingly, US activity, caused December’s equity sell-off.

Since then the Fed has changed course signalling that the tightening cycle may already be over. Far from expecting the Fed to hike rates markets think the next move will be a cut. Lower interest rates boost growth and the current value of future dividend income; it’s no surprise that the Fed’s volte-face has buoyed equities.

The Bank of England (BOE) has followed the Fed’s lead, pulling back from its rate-rise plans citing a weaker global backdrop and Brexit risks. The European Central Bank (ECB) has chimed in saying it would keep interest rates at their current level of zero percent through the summer of 2019, “and longer, if necessary”.

The view in financial markets now is that interest rates in the US, the UK and the euro area will stay on hold through this year. Meanwhile the consensus among economists is that growth in the rich world will slow modestly this year, with growth of 1.3% in the euro area, 1.4% in the UK and 2.5% in the US.

These numbers are respectable and do not set alarm bells ringing. Yet the world is awash with risks from trade wars to a slowing Chinese economy and asset bubbles. All too often what has looked likely to be a modest downturn has turned into something far more severe. What tools do the authorities have to prop up demand should things turn nasty?

The standard response would be to cut interest rates. With rates at 2.5% the US has a fair amount of headroom to do so. The UK, at 0.75%, has less scope and with euro area rates around zero the ECB is running on empty.

More controversial and suggestive of mounting risks to growth, would be to restart quantitative easing (QE). The Fed has an advantage on this front because it started tightening early. The Fed is the only central bank that is unwinding QE, selling assets acquired during the period of extraordinary monetary ease. Slowing or stopping the pace of US quantitative tightening is a subtle form of monetary loosening that is available to the Fed, but not to the ECB and the BOE, which have merely stopped the net purchase of assets. Europe’s central banks would need to restart their now- terminated programmes of QE, something which in policy terms would be akin to pressing a big red button labelled ‘Crisis’.

With monetary policy ammunition running low it would be natural to expect government to bear more of the burden of getting growth going in the event of a downturn. Governments are running much higher levels of debt than ten years ago, suggesting they too are constrained. But borrowing costs are low and in an uncertain world, investors seem to have almost inexhaustible appetite for the debt of large, Western governments.

Last week the Financial Times (FT) reported that euro area governments have started to reverse years of austerity with most countries adopting expansionary fiscal policies which should bolster growth. In the UK the government says that it would be prepared to increase spending in the event of a Brexit shock.

The US is in a different position. It enacted huge tax cuts in early 2018, stimulating the economy when it was close to full capacity. By the end of this year the stimulus from the tax cuts will fade just as the economy is in need of a boost. Mr Trump’s recourse last week to emergency powers to fund his border wall suggests he might struggle to get money from Congress to help bolster growth.

Yet my sense is that the US is probably better placed to counter a downturn than the euro area.

The Congressional battle over funding for Mr Trump’s wall has certainly been toxic. But it says little about the willingness of the Democrats to fund infrastructure projects in the event of a major downturn. Indeed, in the 2016 election one of the few areas on which Mr Trump and Ms Clinton agreed was the case for a substantial increase in public infrastructure spending.

Germany has the scale and scope to ease fiscal policy in a way that would boost the whole of the region. But it is resistant to doing so, favouring strong public finances. Italy and France arguably have greater need for fiscal stimulus but their finances are weaker than Germany’s. In the case of Italy state indebtedness connects to the fragile condition of the banks, which are heavily invested in Italian government debt.

America is not alone in facing tensions on fiscal policy. The recent stand-off between Brussels and Rome over Italy’s plans for deficit-financed spending attests to the tensions between the rules of the single currency and the preferences of member states. Those rules limit government deficit to 3% of GDP and debt to 60% - something which places a constraint on the ability of some governments to boost their economies.

The euro area slowdown kicked in without the ECB even having tightened monetary policy. That’s worrying, not least because it means that the ECB is facing a downturn with interest rates at zero. The downturn in the euro area is advanced and deflationary risks look greater than in the States. (Underlying or core inflation in the US is twice euro area levels.)

At 2.5% there’s plenty of scope to lower US interest rates. And the Fed can quietly ease policy by slowing the pace at which it sells assets. The ECB would need to restart its QE programme. That would be very big news.

As the euro area recovered in 2016-17 concerns about the long-term challenges of low growth and an incomplete monetary union faded. Those problems have not gone away. The way in which president Macron’s reform programme ran up against the gilets jaunes movement shows how things can change. May’s European parliamentary elections will provide an important EU-wide test of the public mood.

The UK is, of course, on a different path. An abrupt or disruptive Brexit would generate intense pressure on the government and the BOE to ease policy. Faced with the risk of a sharp slowdown, or a recession, I suspect the UK authorities would not sit on their hands and do nothing.

The slowdown in Europe and the US is coming through a little faster than expected. It looks manageable and orderly but then most major downturns start out that way. Policymakers would be wise to be thinking about how they’d react if things were to turn nasty.