This was first published in The Times – 05th August 2024
On Monday, Japan’s stock market suffered its biggest fall since Black Monday in 1987. There was contagion as stock markets across the globe crashed.
Last Wednesday, the US Federal Reserve left policy rates unchanged at 5.25 per cent to 5.5 per cent but stressed its bias to ease. By Friday the Fed’s lack of action was already being seen as a policy mistake, as data showed US jobs growth slowing and unemployment rising in July.
Although the Fed described the economy as solid and drew attention to strong private domestic demand, the rate of US unemployment is 0.9 percentage points above the low seen in April 2023, often a harbinger of recession. Now the markets fear a hard landing and expect US rates to be cut by 1.25 points by December.
While the main factor creating market turbulence is fear of a US downturn, Japan’s decision to hike interest rates last week from 0.1 per cent to 0.25 per cent, as well as escalating geopolitical tensions in the Middle East, added to volatility.
The yen had become a source of cheap funding in recent years. A crowded trade has been to leverage cheap borrowing in yen to invest elsewhere. Japan’s rate hike prompted an unwinding of leveraged positions across the globe, and in turn the yen rebounded and Japanese stocks collapsed.
There are important lessons from 1987, not least keeping falls in financial markets in context. On October 19, 1987, the Dow Jones fell by 22.6 per cent in one day and London’s FTSE shed one fifth of its value over two days. This dominated the news agenda. The fear was that this would trigger a global depression. It didn’t.
There are some parallels with the present situation in Japan, especially regarding the trigger. Then, it was poor US trade figures the previous Thursday. Now, it is poor US jobs data last Friday. Then, there had been a small interest rate rise by Germany a week earlier. This time, it was Japan raising rates.
Central banks responded to Black Monday by providing liquidity and cutting rates. That’s what they need to do now. Then, the Bank of England base rate was 10 per cent. It reached a low of 7.5 per cent the following May. But by October 1989 it was up to 15 per cent. That, if anything, should tell us something. The economic damage in 1987 was limited. Unlike 1929 when the Wall Street crash triggered recession, by 1987 markets were slightly detached from economic reality. More so now.
Despite being hit by a succession of shocks this century, the world economy has proved resilient. In 2000, global GDP was $32 trillion. By the 2008 global financial crisis it had risen to $62 trillion in nominal terms. This year, the International Monetary Fund expects the global economy to reach $110 trillion. Despite shocks, the world continues to grow.
For some months, measures of volatility have been low, as markets have not priced sufficiently for risk, leaving them vulnerable to unexpected news. Yet, underlying much of what is happening is uncertainty about where economies and rates will settle. Increasingly, the question being asked is, where is the new normal for growth, inflation and rates? Normalisation is key to understanding the outlook.
Where is the new normal for global growth? A year ago the focus was on globalisation being replaced by fragmentation. Then, at this spring’s International Monetary Fund meetings the talk was of steady but slow growth and a resilient world economy amid divergence.
The world economy lacks momentum. It is not just the US slowing. China, the main driver of global growth before the pandemic, grew by 4.7 per cent in the second quarter, below this year’s 5 per cent target. Any global slowdown exposes the high level of global public and private debt. It’s not only the level of debt but the future relationship between growth and interest rates that is key.
Where inflation settles is critical. Inflation has decelerated significantly since its 2022 peak. In its recent annual report, the Bank for International Settlements noted two secular trends affecting the inflation outlook. The secular rise in the price of services relative to goods and the secular increase in wages. These are interlinked, as services are labour intensive. Yet forecasters always expect global inflation to return to normal and hit inflation targets. But there is no guarantee of this, even though we are in a disinflationary environment, with modest growth and low inflation.
Against this backdrop, where is the new normal for policy rates? Importantly, it is the emerging economies that have shown western central banks how monetary policy should be run. They tightened earlier as inflation rose, and cut sooner, as it eased.
Even as US rates were left unchanged last week the chairman of the Fed described policy as restrictive. Likewise, even after the rate cut here, the Bank of England governor acknowledged that policy was still restrictive. Although policy acts with a lag, rate decisions have become coincident, based on present data. But there is an economic cost for keeping rates too high for too long. A chart in last week’s monetary policy report showed the impact of policy tightening since August 2021 has been to reduce the level of UK GDP by 4 per cent.
A crucial aspect of the forthcoming monetary policy debate is what constitutes the new normal for policy rates. August’s annual gathering of central bankers in Jackson Hole, Wyoming, is focused on the effectiveness and transmission of monetary policy and provides a fresh opportunity for the Fed to have an impact on expectations.
At Jackson Hole just before the pandemic the view was that “r-star” — or neutral policy rates in real terms after allowing for inflation — in the US, UK, Germany and Japan were close to zero. So, if inflation is 2 per cent, policy rates should be 2 per cent. Where is r-star now? It needs to be a lot higher. Rates need to be high enough to keep inflation in check, while low enough to foster growth. Markets are looking for a sense of normalisation.