Economic Commentaries

12

Belatedly ECB head Mario Draghi reduced the benchmark interest rate in May and allowed for even more action if needed, including taking the deposit rate below zero and perhaps buying low quality loans directly from European banks. Meanwhile, at its FOMC meeting Federal Reserve officials suggested a flexible approach to its asset purchase program, allowing that it could even increase the size of its purchases if deemed necessary.

Other Central Banks have since followed the lead of the U.S. and Europe with their stimuli of lowering interest rates. And of course the Bank of Japan is sticking with its own aggressive easing program. Equity markets worldwide have been cheering this latest liquidity injection while bond markets hang tough in the face of decreased sovereign debt supply and diminishing inflation expectations.

Why have Central Banks become bolder, especially in the face of an improved labor market in the U.S., evidence of more lenient lending standards among U.S. banks, and even a smattering of some relatively upbeat economic data reports in Asia and Europe? One reason is that labor markets worldwide remain fundamentally weak. While the jobless rate has fallen to 7.5% in the U.S. a portion of this can be attributed to increased part time work and decreased labor force participation. Euro zone unemployment is at a new record high above 13% and in the periphery it is twice this level.

A second reason is that fiscal austerity remains in place. In the U.S. sequester related spending restraint is in place and war related spending is dropping. However welcome, these adversely affect demand in the short run. In Europe there is a move to reduce austerity by allowing some countries more leeway in meeting budget targets. But this is more window dressing than it is a fundamental policy switch. Meanwhile, export oriented Asian economies are suffering from the competitive consequences of a weaker Japanese Yen.

Finally, monetary authorities are coming to grips with a collapse of inflation. Wage growth remains negligible worldwide and the broad spectrum of commodity prices is trending lower. Minimal pricing power is making it difficult for business to meet revenue goals without more cost cutting. And the fear among policymakers is that this feeds on itself, creating a deflationary expectation. As the Japanese can attest, once a deflationary expectation gets embedded, it is extremely difficult to counteract.

Given these, we suspect the lack of inflation will become an increasing focus of monetary policies. And since Central Banks can never admit defeat, we suspect they will be more apt to err on the side of excessively stimulating rather than the opposite. The hope is that it works and that the global economy soon begins to show demonstrable progress.

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