On 31 October we presented an overview of our Global Economic and Markets Outlook for 2017 Q4 at an event hosted by Thomson Reuters in London. We were joined by former Bank of England policymakers Charles Goodhart and Rachel Lomax. Fathom Director Erik Britton opened proceedings by setting out what we see as the most likely outcome for the global economy, distinguishing our relatively positive near-term outlook from our more muted medium- to long-term growth story.
As we explained in more detail at Tuesday’s event and to clients in a series of presentations over the past few weeks, we believe that the strong cyclical upturn that is in place across most major economies — the UK aside — has further to run. But, after close to a decade of exceptionally loose monetary policy, asset prices look increasingly out of step with fundamentals, and in some areas they look downright bubbly.
Some people — particularly those who want to sell you equities — will tell you that near-record price to earnings ratios can be justified by cheap money. But simple arithmetic tells you that this can be true only if a downward shift in long-term real rates of interest occurs with no corresponding deterioration in the prospects for economic growth.
The difficulty with this argument is that both economic theory and empirical evidence tell us that an economy’s long-term real rate of interest, and its sustainable rate of economic growth, are inextricably linked. They are, to a first approximation, one and the same thing. Using data from 17 major economies stretching back to the 1800s, we showed attendees of Tuesday’s event that on average the two concepts have differed by just 10 basis points.
We see these economic fundamentals reasserting themselves over the next few years. In our central scenario, this occurs through a downward reassessment of long-term growth prospects, combined with an increase in long-term real rates of interest, as investors come to realise that the Phillips curve, the relationship between spare capacity and inflation, is not dead.
The vast majority of Tuesday’s audience agreed that the Phillips curve was still alive, in one form or another. 64% judged that the responsiveness of inflation to the narrowing of output or employment gaps, though still evident, was less than it used to be, while 26% felt that nothing had changed. Both of these responses imply that inflation will begin to rise across most developed economies, and soon if estimates of productive potential are to be believed. Already, the output gap is positive or close to zero in most major economies.
As Tuesday’s panellist Rachel Lomax highlighted ahead of this week’s interest rate hike, the Bank of England appears to share that view, warning in September that the erosion of slack, and the inflationary implications of that, warrant a tightening of monetary policy. Most analysts, ourselves included, correctly took this as a signal that the Bank would raise rates by 25 basis points on Thursday. We were right.
Both the Minutes of the rate-setting meeting and the Inflation Report implied that the Committee has put its faith in the existence of the Phillips curve. As mentioned above, we also believe that the Phillips curve is alive and well, but we part company over the prospects for economic growth. The Committee believes that it will remain above what it sees as the new normal of 1.5% for the duration of its forecast horizon. We do not. As a consequence, and with the UK likely to enter recession early next year, we view Thursday’s move as nothing other than a reversal of the unnecessary, and quite probably ineffective, post-Brexit rate cut. In other words, further hikes are not on the cards.
This deterioration in the UK’s already poor growth performance is likely to raise questions about the timing of the Bank’s first rate hike in over a decade. But as Charles Goodhart stated at Tuesday’s event, with low interest rates leading to distortions in the economy, now “is a good time to start” tightening.
Indeed, until emergency low rates of interest are reversed, debt and distortions will continue to build in the system, rendering the eventual process of monetary policy normalisation an increasingly difficult and distant prospect. Rachel Lomax concurred, noting that holding rates this low for this long “has not been a costless exercise”, particularly as the Bank has put undue faith in macroprudential policy.
Reflecting this, 96% of our audience felt that equities are overvalued, with 74% suggesting that the bubble would get bigger before it bursts. From our perspective, the Bank has not only left itself open to criticism that it has fostered financial instability, but in encouraging the build-up of debt and keeping interest rates low it has harmed the productive potential of the economy. The same applies to other advanced economies.
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