Following the recent and ongoing turmoil in financial markets, largely triggered by the growing uncertainty about the health of the Chinese economy, financial investors have started to expect and demand more actions from the European Central Bank (ECB). In a research note, the British bank Barclays went as far as predicting “more easing before year-end.” The financial institution does not believe that inflation in the euro zone will move to levels consistent with the ECB’s mandate on price stability, namely a rate below but close to 2 percent, anytime soon.
Barclays is not alone in its assessment. Many market observers believe that problems in emerging markets are creating a global disinflationary wave that central banks in developed countries can only contain by stepping once again on the gas pedal. Larry Summers, former Secretary of the Treasury, even thinks that the Federal Reserve should launch a new program of asset purchases.
Indeed, the strong dollar is now accompanied by a resurgent euro. At the same time, prices for commodities have continued to fall, putting new pressure on headline inflation, particularly in the euro area.
Since both central banks, the ECB and the Fed, have a mandate of price stability, would this not be the moment to signal their readiness to act swiftly? If markets expected the answer to this question to be a resounding “yes,” they were sorely disappointed. Euro area core inflation in the month of August was stronger than expected, pulled by domestic demand. At the central bankers’ gathering in Jackson Hole, Vitor Constancio, the vice president of the ECB, refused to play the expectation game. He does not see any urgency to modify the current monetary policy stance of the ECB: “The current phase of low inflation, aside from commodity price developments, is significantly influenced by negative demand shocks both at the global and national level.”
Furthermore, he finds, “in particular, the recent low inflation in the euro area was largely triggered by domestic demand weakness, which probably led to a larger degree of economic slack than was predicted by the usual methods.” However, Constancio concluded that “the link between inflation and real activity appears to have strengthened in the euro area recently. Provided our policies are able to significantly reduce the output gap, we can rely on a material effect to help bring the inflation rate closer to target.”
Even Constancio’s counterpart at the Fed, Stanley Fischer, refused to suggest that the FOMC Federal Open Markets Committee (FOMC) is leaning toward a further delay in the lift-off date. The first rate hike since the beginning of the financial crisis could therefore still come as early as mid September, or at least before year end, in line with what markets expected before developments in China complicated the picture.
If there are any lessons to be learned from recent market behavior, it is that central banks are still too close to being the only game in town. Markets don’t trust their own ebullience, unless fuelled by never-ending liquidity provided by central banks. We are witnessing a game of chicken between investors and central bankers, with the former rehearsing the mother of all temper tantrums and the latter trying to hold firm. Central banks are trying to suggest that the global economy is not falling off the cliff, despite the cooling Chinese economy, while investors seem to suggest that they fear it might just do exactly that. Sticking to their guns matters to both the Fed and the ECB. The tale of the “great divergence” of monetary policies has helped the Fed to approach its first rate increase relatively smoothly. For the ECB, its program of asset purchases has helped to weaken the euro and improve overall financial conditions. Any sudden change in the monetary policy stance on either side of the Atlantic, or even the mere announcement that it might do so in the near future, would call into question what has been achieved since the beginning of the year. Against this backdrop, any dramatic announcements would suggest that central banks are extremely worried. This could increase rather than reduce volatility.
This brings me to the new lackluster economic data from China, which caused stock markets to take another dive earlier this week. Far from constituting a reason to panic, we need to realize that transitions from an investment and export-oriented economy to one more reliant on domestic demand will never be entirely smooth, not even in China. This does not necessarily mean that the Chinese economy is falling off a cliff. However, we all need to reassess our love affair with emerging markets and the BRICS in particular. Just as developed economies are not doomed, it is naïve to think that replacing their predominance with a cluster of emerging markets centered around China was going to be inevitable and fast. The fact that commodity-producing economies are re-transferring wealth back to developed countries is not necessarily bad for the global economy, per se. It is a shift that could even favor the recovery in the developed world, which could once again become the main engine for growth, while many emerging economies manage their difficult transition. I realize that this all sounds like a zero sum game, but then the global recovery that took hold after the financial crisis often looked like one.
Finally, the overreliance on an export-driven growth model is proving to be just as flawed as one over-reliant on debt fuelled consumption. This is important in the euro area context, as the modest recovery that is taking place will not be sustainable if it only depends on exports. What is needed is a greater reliance on domestic demand, investments, as well as consumption. Perhaps some of the capital that is leaving emerging markets will find its way into the real economies of the developed world again. Would that be such a catastrophe?