Abstract
Developments in the past three months have been dominated by the steep decline in crude oil prices. If the lower prices are sustained, and if the decline is not allowed to exacerbate the threat of deflation, this should provide a significant boost to growth in countries that are net oil importers and for the global economy. At the same time, however, data on economic activity in the latter part of 2014 have generally been weaker than expected, with the particularly notable exception of the United States, and inflation in many cases has fallen further below central banks’ targets. These developments have led to additional policy actions in several economies to ease monetary conditions, including a welcome – indeed overdue – major expansion of asset purchases by the European Central Bank (ECB). In financial and foreign exchange markets, there have been further marked declines in government bond yields, to record lows in some cases, and a significant general appreciation of the US dollar against other major currencies.
Forecast summary Percentage change
Notes: Forecast produced using the NiGEM model. (a) GDP growth at market prices. Regional aggregates are based on PPP shares, 2011 reference year. (b) Trade in goods and services. (c) Central bank intervention rate, period average. (d) Average of Dubai and Brent spot prices.
Taking into account these and other developments, including the current economic downturn in Russia and its regional repercussions, and also significant data revisions,1 our estimate of global growth in 2014 has been revised up slightly since the November Review to 3.4 from 3.3 per cent, but our forecast of global growth in 2015 and 2016 has been revised down by 0.2 percentage point in both years, to 3.3 and 3.6 per cent, respectively. Tepid global growth, similar in pace to the past two years, thus seems likely to continue in the short run.
Oil prices (as of late January) have declined by 44 per cent, in US dollar terms, since late October 2014, and by 58 per cent since last June, when prices reached a peak. There is some uncertainty about the causes of the decline. Some considerations suggest that supply factors have predominated. One is the fact that the decline in oil prices far exceeds recent declines in the prices of most other primary commodities (see figure 1).2 US oil production has risen by 80 per cent since 2008 – this increase being larger than total production in every OPEC country except Saudi Arabia – and last year supply disruptions which had partly offset the rise in US output were alleviated, including by a recovery in Libyan production. Moreover, the Organization of Petroleum Exporting Countries (OPEC) decided in November to maintain its production ceiling in spite of the price decline, and Saudi Arabia has made clear its intention not to counter the increased supply from non-OPEC producers. On the other hand, however, disappointing global economic growth, and the resulting slower growth of energy demand, has also surely contributed. The International Energy Agency has lowered its projections for global oil demand for 2015 significantly in the past six months, as has the Energy Information Administration (EIA) of the US Department of Energy, whose most recent projections of global oil prices are assumed in our forecast. Indeed, the analysis in the note on Oil Prices and Economic Activity (on pp. 43–8 of this Review) suggests that demand weakness may have become the main factor driving oil prices in late 2014.
Commodity prices in US dollars
For the world as a whole, the decline in oil prices should be beneficial, spreading the benefits of increased supply and mitigating the effects of weaker demand. For users, the price fall is like an indirect tax cut, raising disposable income for consumers and reducing input costs for producers. Countries that are net importers of oil should thus get a growth boost through increased consumer spending and investment – the boost being the greater the higher is the country's energy intensity of consumption and production. Oil exporting countries will suffer adverse effects, including on government budgets, and some could face financial stress. But for the world economy, the net benefit to growth should be significantly positive.
However, the effects of the decline in oil prices in importing countries will depend partly on the extent to which it has a prolonged downward effect on inflation. In normal circumstances, if inflation were initially close to target and stable, the appropriate monetary policy response to an oil price decline would be ambiguous, with the boost to demand suggesting a possible need to tighten but the short-term reduction of inflation suggesting a possible need to loosen in order to support the credibility of the inflation target. In current circumstances, however, the priority for central banks in most advanced economies should be to ensure that the price decline does not exacerbate the problem of below-target inflation, with the associated threat of deflation, and that core inflation does not fall further from official targets through second-round effects on other prices, wages, and inflation expectations. In some cases, this may mean further reductions in official interest rates, which have been seen in several countries in recent months. In other cases, where there is limited scope for further short-term interest rate cuts, there may be a need to strengthen unconventional measures. Thus President Draghi referred to the increased potential for second-round effects of oil price declines as one of the reasons for the recent expansion of the ECB's asset purchases. Strengthened forward guidance may also be needed to bolster the credibility of inflation targets as headline inflation declines further below them.
Selected economies: inflation
Recent price data for the advanced economies show that the oil price decline has already significantly lowered overall, ‘headline’, consumer price inflation, but effects on core inflation have so far been smaller. Thus in the Euro Area, 12-month headline inflation is provisionally estimated to have fallen sharply to −0.6 per cent in January, while core inflation is estimated at 0.6 per cent, not far below its range of recent fluctuation. In the United States, 12-month consumer price inflation (on the measure preferred by the Federal Reserve) dropped to 0.7 per cent in December, below the core rate of 1.3 per cent, which has fallen only slightly in recent months. Expectations of future inflation, meanwhile, including for the medium term, appear to have declined significantly in recent months: thus the five-year-forward five-year breakeven rate of inflation in the Euro Area implied by financial instruments has recently fallen to about 1.6 per cent. Another worrying development is that recent wage settlements in Germany have been smaller than last year (see figure 5). In any event, with actual inflation, on any definition, already significantly below target in most advanced economies, and negative in many, heightened vigilance by central banks towards core price, and wage, developments, and inflation expectations, will be needed in the coming months.
Recent data on economic activity have generally been weak, the most notable exception being the United States, where the pick-up in growth that occurred after the drop in GDP early last year has been largely maintained. In the Euro Area, growth has remained too weak to make significant further inroads into the high level of unemployment. In Japan, GDP surprisingly declined in the third quarter of last year – the second consecutive quarterly drop. Among emerging market economies, the gradual slowing of growth in China has continued, broadly as expected. In Brazil, there has been little sign of significant economic recovery since the recession in the first half of last year. The Russian economy has been hit hard both by the decline in oil prices and by international sanctions: GDP was virtually flat in the first three quarters of 2014, and more recently a recession seems likely to have begun. Our growth forecast for Russia has been revised down significantly, with an output decline of 3.8 per cent now projected for this year. Only in India, among the major emerging market economies, have there recently been signs of a pick-up in growth.
Several central banks, apart from the ECB, have recently taken action to provide additional monetary stimulus. The Bank of Japan announced in early November an expansion of its programme of asset purchases. Official benchmark interest rates were lowered by 25 basis points in Norway, in December, and in Canada, in January – both advanced economy oil producers – to 1.25 and 0.75 per cent, respectively. Also in January, benchmark rates were lowered in Denmark, in defence of the exchange rate peg to the euro (by 45 basis points, to −0.50 per cent),3 and in Switzerland when the central bank abandoned the cap on the franc's exchange rate against the euro (by 50 basis points to −0.75 per cent). Among emerging market economies, inflation in China fell below 2 per cent late last year, eliciting in November the first reductions in official interest rates (of 25–40 basis points) since 2012. Benchmark rates were also lowered in India in mid-January following the recent decline in inflation. Official interest rates have been raised in the past three months, however, in Brazil, Indonesia, Nigeria, and Russia, in efforts to contain inflationary and exchange rate pressures.
In the United States, the Federal Reserve, having completed in October its programme of asset purchases, is now considering when to start raising short-term interest rates from the near-zero floor where they have stood since December 2008. Recent data, including low inflation and indications of continuing slack in the labour market, still suggest that an early increase in rates would be inappropriate. In our forecast, we have revised our assumption about the timing of the first increase in rates by the Fed, to the third quarter of this year from the second.
Government bond yields have fallen further in most major markets since late October, in many cases to unprecedented levels – negative in several countries at short maturities – no doubt reflecting the downward pressures on inflation and inflation expectations, as well as the monetary accommodation being provided by major central banks. Declines in 10-year yields have ranged from about 20 basis points in Japan to around 60 basis points in the US, Canada, most of the major economies of the Euro Area, Brazil, and India, to about a full percentage point in Italy and the UK. By late January, 10-year yields had fallen as low as −0.1 per cent in Switzerland, 0.2 per cent in Japan, 0.4 per cent in Germany, 0.6 per cent in France, 1.5 per cent in Italy and Spain, and 1.8 per cent in the US. The negative 10-year yield in Switzerland is unprecedented in recent financial history. The only exception to the decline in yields among the major economies is Russia, where 10-year yields in late January were about 13.5 per cent, up from 10 per cent in late October.
In foreign exchange markets, reflecting relative cyclical positions and associated expectations of monetary policy divergence, the US dollar has appreciated further against most other major currencies since late October, by about 8 per cent in effective terms (by the Bank of England's estimates). In late January the dollar's effective value was about 33 per cent above its low of mid-2011, and at its highest level since 2004. The dollar's recent appreciation has been largest against the Russian rouble, amounting to 65 per cent since late October and 96 per cent since February 2014, before the crisis in Ukraine. Its recent appreciation against the currencies of other major advanced economies has ranged from 6 per cent against the pound sterling to 9 per cent against the yen and 12–13 per cent against the Canadian dollar and the euro. Its rise has been smaller against some major emerging market currencies, including the Chinese yuan (2 per cent) and the Indian rupee (against which it has been flat).
The most notable exception to the US dollar's recent appreciation is the Swiss franc, against which the US dollar has depreciated by about 5 per cent since late October. This reflects the Swiss National Bank (SNB)'s removal, on January 15, of the franc's cap against the euro, which had been introduced in September 2011. The SNB explained that while the cap had been introduced, at SF 1.20 per euro, at a time of exceptional overvaluation of the franc, the overvaluation had since diminished, and the recent and prospective depreciation of the euro against the US dollar would involve, under the cap, an inappropriate weakening of the franc against the US currency. (Since September 2011, under the cap, the franc had depreciated by 17 per cent against the US dollar.) The official intervention required by the cap had led to a substantial increase in the SNB's foreign exchange reserves, to $527 billion by November 2014, from $377 billion in September 2011, with an associated growth in its balance sheet: see figure 3. At the same time as removing the cap, the SNB lowered its benchmark interest rates by 50 basis points, with its sight deposit rate being reduced to −0.75 per cent from −0.25 per cent, “to ensure that the appreciation … would not lead to an inappropriate tightening of monetary conditions”. The removal of the cap shocked markets, and in the hours immediately after the announcement there was a jump of about 40 per cent in the franc's exchange value, before it settled down. By late January, the franc's appreciation since the cap's removal amounted to 16 per cent against the euro and 12 per cent against the US dollar. This appreciation will exert additional deflationary pressure on the Swiss economy, where inflation is already negative (–0.3 per cent in the year to December). Further monetary easing may be needed to avoid a recession.
Selected economies: central bank assets
Our forecast is, as usual, subject to a range of risks, a number of which have been discussed in recent issues of the Review. Thus geopolitical risks remain apparent from continuing conflicts in Ukraine and the Middle East. Risks also continue to surround the assumed normalisation of monetary policy in the United States, among which are the risks associated with possible financial market reactions, including outflows from emerging markets. Surprises in the timing of monetary policy normalisation or, perhaps more likely, surprises in economic data which change expectations about the timing, could trigger instability in financial markets and international financial flows. Also, of course, there is a risk that the timing and pace of normalisation, when it occurs, will be mistaken in relation to the needs of the economy, with potential costs that would be particularly high if the mistake were precipitate action that caused the economic recovery to stall.
There are also the risks relating to the continued weak economic performance of the Euro Area, including the risk of political reactions that may increase uncertainty about policies, hinder progress with desirable fiscal and structural reforms, and damage further the cohesion of the monetary union and the European Union. This risk has been illustrated by the recent election in Greece of a government intending to renegotiate Greece's current arrangement with the ‘troika’ (the ECB, European Commission, and the IMF) and seek debt reduction. This has clearly added uncertainty, as some Euro Area policymakers have stated that such renegotiation is not acceptable. It is strongly in the interests of both Greece and the Euro Area to reach a mutually acceptable deal. It would be sensible for Euro Area policymakers to recognise that some loosening of fiscal policy in Greece is imperative, economically as well as politically, and that further restructuring of Greece's debt is required, although this could be done by reducing its net present value (for example, by extending maturities) without reducing its face value. Equally, the new Greek government will need to make a credible commitment to fundamental reforms of the functioning of the Greek state; and paradoxically, given that it is not associated with the ‘establishment’, it may be in a better position to implement such reforms than the parties that have previously been in government. So a constructive resolution should be possible, but it is by no means assured. If such an agreement is not reached, there is clearly a risk of a disorderly Greek exit from the euro. While in itself this would have relatively little effect on the wider Euro Area economy – Greece accounts for only about 2 per cent of the Area's GDP – there would be serious risks of contagion to other, more economically significant countries and hence to the euro itself. The risks illustrated by Greece are likely to become prominent again in other elections in Europe.
Two other sets of risks have been heightened by recent developments. The first relates to the recent steep decline in oil prices. This was not foreseen by any major forecaster or by oil markets, and considerable uncertainty now exists about the future path of prices. Our forecast assumes a gradual and only partial recovery of prices in the next few years from their recent levels, broadly in line with prices in futures markets: the average price assumed for 2016 is roughly half-way between recent levels of around $50 a barrel and the 2013 average of about $100. But an earlier and steeper recovery of prices, generated, for example, by larger than assumed supply reductions in response to the price decline, or by supply shocks, is a possibility, as is a further price decline. These possibilities point to downside and upside risks, respectively, to our growth projections. Even if our assumed path of oil prices broadly materialises, the boost to global demand could be greater than is factored into the forecast; or it could be less, especially if the decline in prices is allowed to exacerbate deflationary forces. The oil price decline will also have financial consequences, increasing external and balance sheet vulnerabilities of oil exporting countries, and damaging the profitability of companies in the energy sector. There will be corresponding benefits for oil-importing countries and energy-using companies, but there is a risk that these gains will be insufficient to offset the economic repercussions of the damage to the losers, for example because of the liquidity constraints they are likely to face.
The second set of heightened risks relates to exchange rates. The recent general appreciation of the US dollar may be viewed as helpful in the context of recent international cyclical divergences, because it should boost net exports and aggregate demand in economies like Japan and the Euro Area, where growth has been weak, while damping demand in the United States, where the recovery has recently been stronger. There is a risk, however, especially if these currency movements go significantly further, that the problem of global payments imbalances will re-emerge in the medium term. The current account of the US balance of payments is in moderate deficit, which we forecast, on our assumption of broadly unchanged exchange rates, to grow somewhat from 2.3 per cent of GDP in 2014 to 3.0 per cent in the medium term. Japan's current account is close to balance, but the Euro Area's current account is in moderate surplus, of about 2.6 per cent of GDP, with notably large surpluses in Germany (the largest in the world in US dollar terms) and the Netherlands, which we expect to remain large. Further dollar appreciation against the euro would tend to widen these imbalances, which could eventually pose a threat to the stability of foreign exchange and financial markets. The strength of the dollar also does not augur well for the debt burdens of emerging market economies, many of whose corporate sectors have borrowed heavily abroad in foreign currency in recent years.
With regard to policies, our forecast of continuing tepid expansion in the advanced economies, in spite of the boost provided by the decline in oil prices, together with their substantial degrees of economic slack, and low and declining rates of inflation, point to the continuing importance of promoting growth by boosting demand.
Structural reforms that boost demand as well as supply can play an important role in many countries: these include reforms that remove impediments to investment, business formation, and job creation, and reforms that promote investment by raising expectations of future growth. Such reforms have much unexploited potential, often because of opposition by vested interests.
The unexploited potential of monetary policy now appears much reduced, with official interest rates generally close to, or even below zero, in most countries and with the ECB having followed the lead of other major central banks by embarking upon large-scale asset purchases. Previous issues of this Review have called for such action by the ECB, and we strongly welcome it. Questions remain, however, about how effective it will be, and the ECB should prepare the ground for even stronger action if the announced programme fails to achieve its inflation objective.
An area of much greater unexploited potential is fiscal policy. Previous issues of this Review have argued for increased government investment, financed by borrowing, to boost both demand and potential output. In the November issue we supported the call by President Draghi for fiscal policy to play a larger role in boosting demand in the Euro Area, including through the use of fiscal space by countries that have it, including Germany, which recently announced its achievement of a balanced budget last year. With government 10-year borrowing costs now having fallen below 2 per cent a year in all the major advanced economies, and below 1 per cent in some cases, including Germany, the potential benefits of borrowing to increase productive government spending are even more apparent.