The first six months of this year have been quite eventful for the global economy. On the positive side, politicians in the US reached agreement on fiscal spending and passed a bill suspending the debt ceiling until March 2015.
But on the negative side, severe weather created havoc in the east of the US, causing economic activity to slow sharply and resulting in a disappointingly low rate of GDP growth in Q1.
In spite of this, the Federal Reserve, now under the chairmanship of Janet Yellen, has continued to taper its monthly purchases of bonds and market-backed securities, and appears to be on course to reach the end of this process later this year. But, although economic growth now appears sustainable, it is still relatively muted and it is expected the Federal Reserve will act cautiously, pausing and fully assessing the situation before raising interest rates.
In China, risks have increased in recent months, particularly surrounding its housing market and the recent surge in shadow banking. House price declines have become more prevalent across China, increasing the risk of a crash unless policymakers take appropriate action in the coming months – possibly by easing regional mortgage restrictions, boosting liquidity available to developers or turning excess property supply into social housing.
But we expect policymakers to remain alert to potential defaults in shadow banking products. Selective, and relatively small, defaults could successfully signal that these products are not risk-free, but policymakers may prevent any large-scale defaults which could hit China’s financial system or its broader economy. In spite of this, the longer-term outlook for China still looks attractive.
Elsewhere in Asia, interest remains in Japan and particularly its experiment with ‘Abenomics’, a policy built on the three ‘arrows’ of monetary, fiscal and structural policy. The monetary boost has been relatively successful, at least in terms of reducing the value of the yen and increasing confidence among Japanese exporters and investors.
But the need to repair Japan’s fiscal situation forced policymakers to raise the consumption tax from 5 per cent to 8 per cent in April, and the early signs are that consumption has declined. We should be able to assess over the coming months whether this is a short-term reaction or the start of a longer-term trend. But we now need to see policy announcements on structural reform – the most important of the three arrows, given that Japan faces an ongoing battle against its ageing society.
Europe has been displaying some similarities with Japan’s previous experience, in particular an emerging trend of disinflation.
Some peripheral economies, notably Ireland and Spain, have cut unit labour costs severely, boosting their international competitiveness, but the unwelcome consequence of this has been wage cuts and high unemployment, resulting in weak domestic economies, low demand and falling prices.
Inflation rates across Europe are generally below the ECB’s target level, and this was a key reason for its recent cut in interest rates. European banks now face a negative rate of interest on any deposits held with the ECB. This is an unprecedented situation and the next few months will show whether it is successful in encouraging lending to small and medium-sized businesses, a necessary condition for any sustainable recovery.