Expect no economic decoupling - but policy decoupling

The recession the Fed not too long ago predicted would not happen, has probably already happened. The spectacular downturn in the ISM Service Index to a level that is consistent with a very sharp fall in output is the latest among a series of warning signals that economic growth in the first quarter is probably going to be negative. We would expect - and disagree with the still prevailing consensus - that this recession will probably last more than just a couple of quarters, maybe a year. This is not a serious slump, but a recession of probably greater intensity and length than the average US recession, which has lasted about 10 months in the past.

Right after the announcement of the slump in the services ISM, the two-year Treasury yield fell below 2%, which means that the market is seriously betting on more extreme rate cuts by the Federal Reserve. That is probably a correct bet. We are still sceptical whether monetary policy can have much effect on an economy that is hit by an exploding debt problem. Cheaper interest rates will not produce more consumption, or investment in such a period. It might help the financial sector to clean up its balance sheets, but will do so in a highly ineffectively and unfair way. Financial players that are virtually insolvent (not just monolines, there many others as well), will not benefit from rate cuts. They will require straight bail-outs, by the private or the public sector, or they will go under. Financial actors that are healthy will be the main beneficiaries. So, low interest rates will not solve the problem, but it will make some people very rich.

But this consideration is not going to play any role whatsoever in the Fed's deliberation. The US central bank will cut. It is what the Fed does when the economy turns down. Later, when they economy emerges from this recession, the Feds and its apologists will claim that by its timely and decisively action the Fed managed to prevent a recession turning into a depression, just as Alan Greenspan's apologists used to say by keeping interest rates at 1% in 2003/2004 prevented deflation, which the US economics establishment was running scared off during that period.

The US recession will in the absence of major financial turbulence, filter gradually through to the euro area through the well-known channels. We expect euroa area economic growth to decline this year, possibly by more than official forecasts are currently predicting. But this does not translate automatically into low interest rates, as some commentators are now predicting. The ECB has until recently discussed raising interest rates. In fact, the majority on the board would probably consider a rate of 4.5% more appropriate to the current inflation environment. In fact, one could argue that the rise in the three-month Libor-Euribor to 5% has pretty much had the desired effect to rain in extra credit growth in Q4 (although we are not close to a credit squeeze, let alone a credit crunch).

The rate rise was blocked by the majority in the governing council on the grounds that it might trigger financial instability. Now that Libor and Euribor rates have fallen back towards more normal levels, a small effective easing of policy has actually taken place. We don't believe that the ECB is going to jump at cutting policy rates, unless there is evidence of a fall in inflationary expectations. The current weakness in the oil price is a good sign, but pressure on food prices will remain strong, and the inflation forecasts are probably once again likely to turn out to be optimistic. So while we expect the ECB to start cutting rates this this year, we do not believe that it is in any hurry. A slowdown in economic growth is not going to be sufficient, unless there are concrete signs that inflation pressures are softening. We do not see happen in Q1 or in Q2 - and we do not want to make predictions beyond that period. So for now, expect the US recession to get worse, expect some noticeable spillovers to the euro area, but no change in monetary policy. A lot of people won't like it. While do not believe that the euro area can decouple from a deep US recession, we are no longer in the same situation as in 2001 either. What is almost certain not to decouple is monetary policy. The ECB is not going to follow the Fed into negative real interest rates this time.

 

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