30 Jun 2021

Monetary policy: emerging from the emergency

Philip Shaw, Ryan Djajasaputra, Ellie Henderson and Sandra Horsfield

London Economics Team

The rapid spread of the Delta coronavirus variant across the globe is a cause for concern. However, evidence suggests that vaccinations are an effective tool against this new strain. In this Global Economic Overview, we maintain our view that the world economy will experience a robust recovery from the pandemic and have left our forecasts broadly unchanged.

Global Economic Overview - June

Summary

Global

While the number of global daily cases has continued to trend lower over the last two months, the key risk to global growth prospects continues to be the pandemic. The rapid spread around the world of the more transmissible Delta variant, which was first detected in India, is a cause for concern. However, evidence suggests that vaccinations are an effective tool against this new strain, breaking the link between infections and hospitalisations. Despite the rapidly evolving risks, economic sentiment continues to track higher, resulting in some central banks heading towards monetary policy tightening. On the whole, we maintain our view that the global reopening of society will lead to a robust recovery from the pandemic. Consequently, we have left our world economic growth forecasts broadly unchanged at 6.1% in 2021, with a slight 0.1 percentage point reduction stemming from downgrades to India, and 4.8% in 2022.

United States

The US expansion continues at a robust pace. Still, although the background is one of the individual states reopening their economies, we see no strong reason to shift our gross domestic product (GDP) forecasts from 6.9% for this year and 4.9% in 2022. Our view of inflation prospects remains aligned with most Federal Reserve policymakers, namely that price pressures are temporary. Even so, the Federal Open Market Committee (FOMC) seems to be taking gradual steps towards policy normalisation. Although our base case is that quantitative easing (QE) tapering will begin in December this year, and the first increase in the Fed funds target will occur two years later, the risks are tilted toward earlier moves, especially if inflation does not subside soon. On fiscal policy, a bipartisan infrastructure deal has been struck, but it remains to be seen if this will pass Congress due to the Democrats’ likely attempts to pass other spending measures at the same time.

Eurozone

Within the euro area, the easing of social restrictions supports a rebound in economic activity. Numerous indicators point to a strong second quarter, reinforcing our view on the region's economic growth this year. We anticipate a GDP expansion of 4.8% in 2021, an upgrade from our previous forecast of 4.5%. Meanwhile, monetary policy is set to remain accommodative. We continue to expect no change in interest rates at the European Central Bank (ECB) until the fourth quarter of 2023. For markets, monetary policy – and in particular QE – continues to be a critical influencing factor, with the most notable development this month being Greek five-year yields turning negative. Expectations over the global policy outlook are also influencing currency markets, with the euro weakening against the US dollar this month. However, we stick by our euro year-end targets of $1.25 in 2021 and $1.30 in 2022.

United Kingdom

Despite a concerning rise in Covid-19 cases, the evidence so far is that vaccination offers good protection from severe illness. Given this, the government seems intent on ending social restrictions on 19 July. This reinforces our view that the economic recovery will proceed, probably even a little faster than previously thought. We have lifted our 2021 GDP growth forecast by 0.2 percentage points to 7.9% and acknowledge it could be higher still. Concerning policy, we detect more of a hawkish tone in the Monetary Policy Committee's statements than the market, driven by concerns that the rise in inflation could persist for longer. Although our baseline case is that a first policy tightening will come in the second quarter of 2022 via some reversal of QE, there is a chance that this is brought forward and even that the policy rate is raised at the same time. 

Global

Globally, the pandemic remains a key theme for economic prospects. Over the last two months, the number of  daily cases has continued to trend lower. However, risks remain, the principal one being from more transmissible variants, such as the Delta strain, which is a factor behind some very early signs that global cases may be starting to rise again. In the UK, it is the dominant strain representing 99% of cases and has led to a sharp increase in infections.

Moreover, there are signs that it is emerging elsewhere, for example, in the US, where it is estimated to represent 20% of cases and in Europe where clusters are forming. In a further development, India’s Health Ministry has identified a "Delta+" variant in several states, which early analysis suggests could be even more transmissible than the original Delta strain. Although this represents a risk to the growth outlook, the rising number of vaccinated people across advanced economies reduces the likelihood of social restrictions being reintroduced. 

However, we are cognizant that vaccination rates also need to rise further in emerging markets, highlighting the need for Covax to be implemented efficiently. Broadly, we maintain the view that the global reopening of society will lead to a robust recovery, with data such as the global Purchasing Managers' Index (PMI) highlighting momentum. Therefore, our forecasts see little change – there is just a small 0.1 percentage point downgrade to 6.1% in 2021 due to India, while 2022 is maintained at 4.8%.

Amid the global easing of social restrictions and strengthening demand, one market segment that has seen some notable moves has been commodities. For example, year-to-date oil and gas prices have witnessed gains of 47% and 42%, respectively, while other hard commodities such as iron ore and copper, among others, have also seen double-digit gains. Perhaps the most prominent price gyration has been in US lumber, where a housing renovation boom drove an 88% gain, only to see prices drop 36%. The broad point to take from all of this is that the sharp rebound in activity is pushing up prices given factors such as supply shortages. Ultimately, this is showing up in various inflation figures, albeit temporarily.

Countries which have reported occurrences of the Delta variant

China has not been immune to these price pressures, with annual producer price inflation rising to 9% in May – the fastest pace in 13 years. Mining and quarrying have been driving this increase, with oil prices nearly doubling in a year, albeit from a very low base. Chinese policymakers have voiced their concern regarding this spike in factory gate prices and have felt it necessary to intervene to ease pressure on key commodities. Policymakers have tried to relieve the supply shortages by releasing national reserves of copper, aluminium and zinc, while also attempting to reduce the burden of rising costs on farmers by providing $3.1 billion in one-off subsidies.

Over the last year, the Chinese yuan has rallied considerably – the currency hit its strongest level in more than three years in May. Following this, the People's Bank of China (PBoC) has sent a clear signal to markets that it has reached its tolerance level with this appreciation by hiking its foreign exchange (FX) reserve requirement ratio for financial institutions by 2 percentage points to 7%, the first such move in 14 years. The hike aims to boost demand for foreign currency by reducing onshore FX liquidity, cooling the appreciation. The success of this is yet to be seen – it may merely be a signal of intent – but it does raise questions on alternative tools the PBoC has at its disposal to guide the yuan, such as whether the counter-cyclical factor (CCF) could be reinstated to counter "irrational" appreciation. 

One of the key themes across developed economies seems to be housing market strength. Ultra-low interest rates and large pots of excess savings accumulated over the course of the pandemic have boosted demand for residential property and resulted in house prices in many countries soaring. This has led to central banks across the world voicing concerns over a potential housing market bubble appearing. In New Zealand, one such example of where the housing market is running red hot, the country's central bank has even been instructed to widen its remit to consider the impact of policy decisions on house prices, illustrating the tools available to rein in the market.

Are ultra-low interest rates causing housing markets to run red hot?

United States

In the US, new Covid-19 infections continue to track lower as more of the population is inoculated against the virus. However, risks remain, with 20% of Americans unwilling to receive a vaccine, slowing progress. There is also concern over the more transmissible Delta variant, with the country's Centers for Disease Control and Prevention (CDC) warning that it will become the dominant strain. Despite this, many states have continued to ease restrictions, such as New York, which allowed workers to return to offices earlier this month. Surprisingly, this has not translated into a pickup in visits to workplaces, reflecting that activity may not immediately respond to an easing of restrictions. Consequently, we have held our GDP forecast steady at 6.9% for 2021 and 4.9% for 2022.  

Following the pandemic lows, the US labour market is roaring back to life. Indeed, that is what would be suggested by a National Federation of Independent Business (NFIB) survey, which found that a record 48% of small businesses reported unfilled job openings in May. However, this reading hides lingering weakness in labour supply, as the participation rate struggles to fully recover from the pandemic trough. It is expected that once the generous enhanced unemployment benefits expire and schools fully reopen, easing childcare concerns, participation should recover and somewhat plug the mismatch between supply and demand. Upcoming labour market statistics should reveal whether this rings true. 

Google Mobility data for the US reveals no rush back to offices

Despite clear evidence of price pressures within the US economy, Federal Reserve Chair Jerome Powell has remained committed to the message that this upward momentum in prices is transitory in nature. Households seem unconvinced, with consumer inflation expectations, as measured by the New York Fed Index, racing ahead, with the median view of inflation in three years hitting an eight-year high at 3.57%. This questions whether the Fed’s so-called "open mouth operations" have lost their touch, failing to guide household expectations lower. Our baseline expectation is that inflationary pressures will indeed subside, although we acknowledge the risk of more persistent price rises than first envisioned.

June’s FOMC meeting left the Fed funds target (0-0.25%) and the pace of QE (at least $120 billion per month) on hold, but there were modest steps towards policy normalisation. First, Chair Powell acknowledged the committee had started to discuss the timing of tapering bond purchases. Second, the "dot plot" showed seven members looking for higher rates next year (up from four in March) and 13 by 2023 (up from seven in March). But while the Fed’s median core inflation forecast is now 1 percentage point higher at 3.4% in the fourth quarter, inflation is still forecast to subside to 2% or so over the following two years. Five-year Treasury yields have climbed 10 basis points to 0.90% over the past month, but 10-year yields are 13 basis points lower at 1.48%.

Fed says inflation spike is transitory – households’ expectations show they are dubious

Markets are pricing in a slightly more aggressive Fed in the near term while appearing more convinced that inflation will be under control – 10-year inflation breakeven rates have slipped by 12 basis points since the start of June to 2.35%, a near three-month low. Our base case remains that tapering begins in December, but an extended run of strong inflation data (not our base case) could result in a September start and an earlier Fed funds hike than our central view of one in the fourth quarter of 2023. As trailed previously, the Fed raised its technical rates (the interest rate on excess reserves (IOER) and the reverse repurchase program (RRP) rate) to 0.15% and 0.05% in response to the softness of overnight rates (various repo rates and the Fed funds market itself) and record takeup of the reverse repurchase facility.

A bipartisan infrastructure deal was reached by 10 "moderate" Senators from both sides of the aisle. This totals $1.2 trillion over eight years, $579 billion of which is new cash and will be funded by unused Covid-19 programmes, better tax enforcement and sales from the Strategic Petroleum Reserve. However, it does not include social spending. President Joe Biden threatened to veto the bill unless various social and environmental measures from his Family Act plans are also passed, though he has since backtracked. Instead, the Democrats are embarking on a complex plan to pass a separate bill to the bipartisan package through Congress via "reconciliation" to prevent a Republican filibuster in the Senate.

Eurozone

The euro area saw restrictions eased again this month, with announcements in France and Belgium further supporting economic momentum, which is evident in indicators. The region's PMI currently stands at 59.2, while more timely data from Google Mobility shows retail and recreation activity at its highest since August. As such, we continue to pencil in a strong recovery across the rest of this year, with our forecasts upgraded to 4.8% in 2021. However, this is partly attributable to a revised estimate for the first quarter (now -0.3%, compared with -0.6% previously). This in itself was heavily influenced by a 7.8% quarter-on-quarter rise in Ireland. This will not be repeated in the second quarter, but a return to growth elsewhere should offset any retracement in Ireland. 

Along with the rebound in economic activity, the euro area is beginning to see a pickup in inflation – May’s inflation reading stood at 2%. A big contributing factor to this has been energy prices, which contributed 1.2 percentage points to the annual rate. Other factors such as base effects and supply bottlenecks should also push inflation higher through this year. Nonetheless, these effects should prove transitory and prices should moderate over 2022. However, while this is very much the central view at the ECB, President Christine Lagarde did add a "but" at her last press conference, noting that core inflation had risen in the last couple of months. Still, any sustained rise in inflation will be dependent on the labour market. To date, unemployment has edged lower to 8% from a peak of 8.7%, and given the expected economic recovery, it should continue to fall. The ECB’s own forecasts see unemployment reaching pre-pandemic levels in 2023 and wage growth standing at 2.4%. But even amid this recovery, inflation is only projected to stand at 1.4%, below the central bank's target. The message that can be taken from these forecasts is that policy is set to remain accommodative. If anything, June’s meeting was more dovish than we expected, with the stepped-up pace of QE being maintained for another quarter, despite the pickup in activity. Nonetheless, our central view remains that the PEPP will end next March and that the first interest rate increase will not occur until the fourth quarter of 2023.

Eurozone PMIs point to a sharp recovery in economic activity

In a rather staggering change of fortune from the height of the Eurozone debt crisis of 2011-2012, Greek five-year government bond yields briefly turned negative this month. Of course, Greece is not unique in this regard – all other 18 member states of the Eurozone bar Italy currently trade at negative five-year yields. QE is a clear anchor for this; since March 2020, the ECB has bought Greek debt securities via the PEPP and currently holds 30% of outstanding issues. Still, Greece only returned to the market again in 2017, having been bailed out and funded through official programmes. This shows Greece’s remarkable economic progress and the hunger for yield amid abundant liquidity in the financial system.

Looking at the wider backdrop, concerns had been voiced that the pandemic would lead to a decline in birth rates, exacerbating what is already a worsening demographic picture in Europe. In the event, it is not clear that this is happening. The monthly birth figures for Germany, for instance, hit their highest March reading in 23 years. That needs to be viewed in light of the general trend higher in German births between 2013 and 2016, which has been broadly maintained since. In turn, that appears linked to the step-up in net migration that preceded it. Elsewhere in the Eurozone, the picture is somewhat less clear, but so far, there is no sign of an aggregate sustained plunge.   

The euro has weakened somewhat over the past month, having previously moved up again in April and May after its falls in the first quarter. The bulk of its latest move can be attributed to the more general strengthening in the US dollar, which accounts for the largest share in the euro’s trade-weighted basket. Different expectations for monetary policy appear to have driven much of this. Despite both the Fed chair and the ECB president having stressed that they see current inflation rises as transient, markets have priced in that the Fed will lift rates sooner than the ECB. We suspect the Fed may be more patient than many expect, which could help the euro recover some ground.

The euro’s recent weakening looks related to divergent monetary policy expectations

United Kingdom

Accelerating Covid-19 infections amid the rapid spread of the Delta variant, which now accounts for virtually all new cases in the UK, has prompted the government to delay the final step of unlocking by four weeks to 19 July. Promisingly, data so far has pointed to a high effectiveness of vaccines against severe illness with Delta, and hospitalisation and fatality rates have risen by much less than infections. Many of the worst hotspots, including Manchester, Edinburgh and nearby areas, are linked to below-average vaccine uptake rates. This also can be seen as a sign that vaccines are working. Health Secretary Sajid Javid has indicated the new 19 July plan is on track.

The delay to "freedom day", at which all remaining restrictions are lifted, is undoubtedly significant symbolically. But it is less so for aggregate economic output. Virtually the only businesses still fully shut are nightclubs. Based on total sales figures of £1.18 billion in 2015, according to Mintel, we estimate them to have contributed just 0.03% to GDP that year. The wider hospitality industry’s warnings of lost sales of £3 billion are more significant, but may still cut 2021 and 2022 GDP growth by less than 0.15 percentage points each. Moreover, we note that despite the delay, seated diners are clearly up on pre-pandemic levels already since the reopening of indoor hospitality in mid-May.

Most of the UK’s Covid-19 hotspots have below-average vaccination uptake rates

A broader key question is how the labour market is faring. Unfortunately, the main labour market data are currently unreliable, being based on pre-pandemic population projections. The Office for National Statistics (ONS) will adjust these from July. In a methodological note, the ONS revealed major revisions are on the cards. Instead of a drop of 1.2 million in the overseas-born population and a rather implausible 1.57 million rise in the UK-born population between the fourth quarter of 2019 and the fourth quarter of 2020, revised numbers will report a 112,000 rise in the overseas-born population and a 2,000 fall in the UK-born population. This will push down the employment level by 207,000 and lift the number of unemployed people. The unemployment rate will only rise by 0.2 percentage points, however. 

Whether the new estimates are closer to the mark is, however, uncertain. A different clue as to how the UK population has evolved through the pandemic comes from primary school applications data. In England, applications to primary school starting from September 2021 dropped by 5.1% from the previous year. The children eligible for these school places were born between September 2016 and August 2017. Yet, the number of births during this time was only 2.7% lower than in the prior year. More late applications than usual and more parents choosing to home-school may explain some of the gap, but the bulk of it is likely due to outward net migration, exacerbated by Brexit.

More rapid UK economic growth due before it eases back

Bank of England (BOE) data show that household deposits rose to £1.7 trillion in May. On our calculations, the level of "excess savings" (household cash in banks and building societies that exists purely due to the pandemic) now stands at £139.8 billion, an increase of £2 billion in April. The recent easing of this build-up, no doubt on the back of the opening up of non-essential retail and hospitality from mid-April, resulted in a sizeable boost to spending over the spring. Notably, households are not yet drawing down on these buffers, implying that high levels of high street expenditure can be maintained, at least through the summer.

Revisions to quarterly GDP estimates show only minor changes, with the quarter-on-quarter contraction in the first three months of the year revised to -1.6% from -1.5%, but we have nudged up our 2021 forecast to 7.9% from 7.7%. Growth above 8% this year is still a real possibility. The BOE's Monetary Policy Committee voted to maintain its stance in June. Still, members were wary over the rise in inflation to 2.1% and more labour market tightness, perhaps doubting that the rise in inflation is transitory. We still see the first tightening in the second quarter of 2022 via a reversal of QE. But if signs of price pressures are persistent, we would not rule out an earlier move and even a small hike in rates at the same time. We have trimmed our mid-year forecast for the pound due to the firm US dollar, but we still see cable at $1.44 by the end of the year.

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