26 Jul 2017

Economic Insights - July 17 - 21, 2017

Article Image: 
by Robin J. Anderson, Ph.D., Senior Global Economist
Table of Contents: 
  • Light week:  Last week’s trickle of economic data was consistent with the continued coordinated pickup in growth in the United States, Europe, Japan, and China. 
  • What a difference a year makes: Over the last year, bond yields have moved from ultra-low to low. At the same time, monetary policy has pulled back from the edge. Central bankers are no longer looking for the next extraordinary tool. 

Light week

Last week, there was not too much new data, but the numbers were generally decent. For the United States, June housing starts increased sharply after several sluggish months. Headline starts ticked up 8.3% month-over-month as building permits, which lead starts, accelerated 7.4%. Multifamily starts increased for the first time since December, as single-family starts regained momentum. Single-family starts remain well below long-term averages, and, going forward, continued pent-up demand should keep the housing market supported. The Conference Board’s Leading Economic Index (LEI) grew  the most since December 2014, a good sign for growth going into the third quarter. However, the first manufacturing surveys for July moderated. The Empire Manufacturing Index dropped about 10 points. The Philadelphia Manufacturing Index continued to come off of a 33-year high. Jobless claims remained extremely low, at only 233,000. 

The European Central Bank’s (ECB) lending survey showed bank lending standards and credit growth healing. European consumer confidence hovered near its post-crisis peak. Initial purchasing manager indexes (PMIs) for July weakened some, with the composite PMI at a solid 55.8, compared to 56.3 last month. Japan’s manufacturing PMI softened up slightly, declining from 52.4 to 52.2.

In general, economic data continued to pick up globally. This week’s data flow will provide more information about the state of the economy. The U.S. second-quarter GDP report will be released on Friday, along with the annual revisions of the last three years of data. We expect a rebound in growth from the seasonally weak first quarter.  Stay tuned.

What a difference a year makes

Last summer, developed market government bond yields collapsed. The U.S. ten-year Treasury yield dropped to 1.35% in early July, and the ten-year German bund had a negative yield through the late summer. At the same time, central banks developed new weapons to fight the scourge of falling prices and weak growth. The ECB and Bank of Japan had outsized asset-purchase programs, or quantitative easing programs, and slashed bank deposit rates well below zero. By the end of the 2016, both banks re-upped their programs. The ECB extended the time horizon of its asset purchases. The Bank of Japan switched to a yield peg, buying whatever bonds it could to keep the 10-year government bond, or JGB, yield at 0.0%. Post-Brexit, the Bank of England cut its policy rate to the bone. The Federal Reserve was on hold until year-end, worried about “global financial conditions” and deflationary pressures.

Analysts were wondering what extraordinary policy was next. Would the Bank of Japan go into explicit monetary finance, or helicopter money? Would the Fed ever consider some sort of negative interest rate policy?

Fast forward one year, long-dated government bond yields have picked up from ultra-low to low. Central banks are not pushing the boundaries of monetary policy out further. In general, they are moving back inside the lines. The Federal Reserve increased the fed funds rates two times so far this year, and is broadcasting loudly and clearly its intentions to start unwinding its balance sheet. The Bank of Canada raised its policy rate in July. The Bank of England has sent mixed signals about its path forward.  

The ECB is shuffling toward the door. The latest policy meeting and press conference reaffirmed that the ECB will likely reconsider the size of its asset-purchase program in the fall. The ECB’s  President Draghi continued to feel confident in growth, although he worried about the recent weakness in inflation. That said, he also restated that reflation has replaced deflation.

The Bank of Japan may be the last to exit extraordinary policy, but it’s not piling on more easing actions either. The Bank of Japan yet again reaffirmed its asset-purchase program, and, again, cut its inflation forecasts. This time around, the Bank reduced the March 2018 forecast from 1.4% to 1.1% and the March 2019 forecast from 1.7% to 1.5%. Of course, headline inflation is running well below those levels, at 0.4% year-over-year.[1]

Central banks have pulled back from the brink. But, have they declared victory too early? Global growth has improved significantly over the last 18 months or so. Europe has transitioned from tenuous recovery to a self-sustaining expansion. The U.S. manufacturing and investment cycles have recovered from the dollar-oil shock of late 2015 and early 2016. Even real growth is decent in Japan. But, inflation is not cooperating. Inflation reports have generally surprised to the downside this spring and summer. More broadly, core inflation remains below bank targets in many regions.[2]

Central bankers could be concerned about another type of inflation: asset price inflation. With deflationary risks down and growth reasonably okay, policy makers likely want to stop the price distortions coming from very low bond yields. But, they are in a bind.

Market valuations are getting lofty. But, underlying inflation could be signaling something about weak demand, which if ignored, could lead to policy error.

 

[1] For a detailed summary of Central Bank actions for major developed markets, check out our global investment strategist, Seema Shah’s, Central Bank Watch: https://www.principalglobal.com/knowledge/insights/central-bank-watch.

[2] Seema also talked about how Central Banks view surrounding the latest recent weakness in inflation here: https://blog.principal.com/2017/07/20/short-and-sharp-the-twisted-relationship-between-central-banks-and-inflation/

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