10th July 2013
Invesco chief economist John Greenwood says it will take a decade to return to pre-crisis levels of real GDP in the UK because public spending remains too high.
In his quarterly update issued today, he says: “Neither the Chancellor’s Spending Review nor the arrival of Mr Carney will immediately transform the outlook in my view, but with public spending set at £745 billion or 43% of GDP in 2015-16 it is now, in my opinion, going to take a decade to return to pre-crisis levels of real GDP.
“Unfortunately even the proposed partial welfare spending cap (which excludes most pensioner benefits) to be imposed from April 2015, and the elimination of automatic or ‘progression’ pay hikes in the public sector in my view, will not ensure that the excessive growth of Britain’s public sector is properly curtailed. There are still too many areas of ring-fenced (protected) government spending, and too little commitment to long-term fiscal soundness.”
In terms of market turmoil due to the US Federal Reserve discussing tapering, Greenwood says that what really matters after the abrupt falls in equity and bond markets is whether the underlying progress of economic recovery is affected with the impact on mortgage interest rates in the US being key.
“The response in financial markets was probably faster and more violent than Fed officials intended, as evidenced by the subsequent chorus of Fed governors and presidents echoing Bernanke’s view that a Fed funds rate hike will not happen any time soon,” he says.
Greenwood says that the Fed should not have been so surprised. Market participants had relied on forward guidance to leverage up on longer duration assets so an indication of a change of policy led to the sudden unwinding of those positions.
“Although market rates have risen, what really matters is whether the underlying progress of economic recovery is affected. The most sensitive arena will be mortgage interest rates and their impact on the housing recovery, a result we will not know for some weeks,” he says.
“The key question is whether the unintended rate increases act to tighten monetary conditions, or whether continued Fed easing and asset purchases counteract the tightening. Although 30-year fixed rate mortgages have risen by nearly 1.2% from 3.4% to 4.5% it seems unlikely that this will have any drastic slowing effect on the housing recovery. The rate increase is similar to the temporary jumps in rates seen in 2009 and 2010 both of which were ultimately overpowered by Fed easing actions.”
Greenwood also sees a mixed picture in terms of other US economic data. He says: “The final release of real GDP data for the first quarter was revised down significantly. Initial and revised estimates of 2.5% and 2.4% respectively were lowered to just 1.8% annualised – a notable reduction by past standards. Key elements of the revision included lower consumer spending due to the impact of tax increases at the start of the year, and declines in business investment and exports reflecting the weaker global economy.
“Since April an array of data has suggested some further moderation in growth. For example, Citigroup’s Economic Surprise Index – a rolling compilation of the performance of economic indices relative to market expectations which was notably weak in late May and early June. Although the trend of data releases has improved since mid-June, the index is tracking well below the performance of last autumn or the first quarter of this year.
“I expect real GDP growth to reach only 1.7% for 2013 as a whole and inflation to remain around 1.6% – below the Fed’s unofficial target of 2% – due to sustained low money and credit growth interacting with the continued existence of spare capacity.”
In terms of the Eurozone, Greenwood says that the European Central Bank’s refusal to engage in quantitative easing “has imposed serious disinflationary pressure on the eurozone, with the annual HICP inflation rate falling to 1.2% in April and 1.4% in May”.
He adds: “The ECB revised down its GDP forecast for 2013 to – 0.6% (in line with ourselves and the consensus), and inflation to 1.4%. However, whereas the ECB is forecasting a recovery to 1.1% growth in 2014, on my assessment of current policies it is hard to project any sound basis for a sustained recovery”.
For the United Kingdom, Greenwood says that by mid-August “we should know if Mark Carney has succeeded in persuading the other members of the MPC either to adopt some form of conditional ’forward guidance‘ to keep interest rates low, or to engage in additional asset purchases”.
“Meantime the economy should continue to reflect the broadening set of improvements that have started to be reflected in the data this year. In addition to the steady rise in employment – a trend that has been in place for two years now – the housing market has notably strengthened during the recent months. In part this was due to the two official stimulus schemes – ‘Funding for Lending’and the initial phase of Chancellor George Osborne’s ‘Help to Buy‘ scheme. For the year as a whole, I expect 1.2% real GDP growth and 2.7% inflation”, he says.
In terms of Japan, Greenwood says expectations are undoubtedly high, but the big question is whether the BOJ can induce sufficient changes in behaviour amongst the commercial banks whose lending has been static or falling for most of the past decade, or amongst the firms and households that have been unwilling to increase their indebtedness by borrowing more. So far, he says, the evidence is mixed. “Loans have increased only marginally and banks are still finding that they have more deposits than they can allocate to loans. A full assessment of Abenomics must await more evidence”.
In conclusion, Greenwood suggests that central banks cannot entirely control the impact of “interest normalisation.”
He says: “In the first five months of the year to 21 May the MSCI World Index increased by 13.6% in US$ terms. Since then, and following Ben Bernanke’s testimony to Congress on 22 May, world equities fell nearly 8% before recovering nearly half their lost value. This sharp correction and the abrupt increase in volatility is both a reminder of the sensitivity of all markets to central bank policies, and a timely reminder that central banks cannot entirely control the impact of interest rate normalisation that major economies must undertake over the next three or four years.”