We are now well into the second phase of post-financial crisis recovery. The first, terrifying phase was the period when central banks had to cut interest rates to zero and then develop and deploy new, unconventional weapons, including QE.
The European Central Bank (ECB) had to be more imaginative than others, as it tried to overcome political opposition to QE from northern European countries.
It invented a myriad of disingenuously named programmes and funds, including the SMP, the ESM, the EFSF, and OMT, until it finally felt able to cross the rubicon and speak the name of QE in January this year – although this was probably too late.
These tactics warded off the complete collapse of the global financial system. But now, in the second, chronic phase, an acute shortage of demand for goods, services and loans is prevalent. This is being driven by a combination of demographics, corporate and household deleveraging, and change in the composition of the workforce towards more part-time and semi-retired employees.
In the US, for example, the participation rate – or proportion of the working age population in work or looking for it – has fallen to levels last seen in the late 1970s.
And the U-6 measure of under-employment is still high. That captures the unemployed, alongside those who have searched unsuccessfully in the last year and have now ceased looking, and people working part-time who would rather be full-time. This figure stands at 10.8 per cent currently, having peaked at 17.1 per cent in 2009, when it was typically in a range of 8-10 per cent pre-crisis.
It would also be an error to dismiss the very powerful effects of the lingering fear that the 2008 crisis will repeat itself. The psychological damage was immense, and the most dangerous symptom of this is the creeping spread of deflation.
This is caused by the “paradox of thrift” – the idea that savings rates have hardly fallen since 2010 in many parts of the world, including Europe. The US consumer’s reluctance to spend the windfall created by the recent oil price fall – shown in stubbornly poor retail sales data – bears testimony to this effect.
DEFLATION TAKES HOLD
The old linkages between growth, employment and inflation have gone. The classic Phillips curve doesn’t hold anymore. Deflation is spreading like a virus around the world, so central banks are easing monetary policy in a desperate attempt to stimulate their economies and export deflation via a weaker currency. The latest and most significant example of this is China, but India, Denmark, Canada, Australia and Singapore have also joined the fray.
The combined effect of all of the above is that we now have a world with zero return on bank deposits and one that is awash with liquidity – but with nowhere for it to go, except into asset markets.
Cash is flowing into markets, whether they be stocks, safe-haven bonds, property, classic cars, or wine – and we have not seen the end of this yet. All of these markets will make new highs.
The problem is that, while these asset prices may rise due to the miserable alternative returns available for capital, fear of unemployment, or subdued rises in real earnings from part-time work mean that the bulk of the population doesn’t feel wealthier.
The US Federal Reserve has repeatedly reminded us that rate rises are not inevitable, and that its decisions are data-dependent. Mega corporates such as Microsoft, Procter & Gamble and Pfizer are reporting lower earnings due to the strong dollar.
The global currency war is in full swing, and the Fed hinted that it was looking at the dollar’s strength when it said it would take “international developments” into account. All of this leads me to find it almost inconceivable that the Fed will raise rates this year.
Roughly €2 trillion of Eurozone government debt, and even some corporate bonds, offer negative yields. Even after recent increases in yields, 10-year German and 10-year Japanese government bonds offer 0.50 per cent and 0.47 per cent respectively.
So why on earth are 10-year bond yields in the US standing at 2.20 per cent? Yes, the economy may look great compared to virtually everywhere else except the UK, and the employment situation may seem encouraging, but this will soon lead to renewed dollar strength.
That will offer foreign investors the prospect of a foreign exchange gain, on top of their 2.2 per cent yield. What’s not to like? I suspect yields on US 10-year bonds will hit 1.5 per cent, and this is now a stand-out investment opportunity for 2015.
But QE is failing to stimulate economies or inflation and, more importantly, is only provoking modest rises in expectations for future inflation. Look at Japan, for example, where the central bank’s forecast for full-year 2015 core CPI is 0.8 per cent, compared to its target of 2 per cent. This is despite the extraordinary expansion of its balance sheet, which has been one of Prime Minister Abe’s key aims.
The question is, in an economic sense, are we all turning Japanese? I really think so.