For those who lived through the high-inflation era of the 1970’s, these are strange economic days. Inflation has been replaced by deflation as a primary economic concern in many nations (unless your economy depends on oil). Political leaders and central banks in these countries have stepped up their actions to combat deflation and spur growth, or announced intentions to do so.
Japan has been fighting this battle for years. An unexpected slide back into recession in the third quarter of 2014 prompted Prime Minister Shinzo Abe’s call for snap elections intended to be a referendum on his stimulus and economic reform programs known as “Abenomics.” Abe prevailed in the election but has a much harder battle ahead reforming Japan’s economy.
Meanwhile in the U.S., the Federal Reserve ended the bond-buying “Quantitative Easing” (QE) program last year but refuses to declare victory despite recent economic improvement. Inflation hovers well below the 2% target mark, and any unexpected signs of weakness may delay a “scheduled” rise in interest rates in mid-2015.
Now the Eurozone and China are expected to take center stage in the deflationary battle, as they join Japan and the U.S. in increasing levels of economic stimulus.
European Central Bank (ECB) President Mario Draghi increased speculation about a stimulus package during an interview with Handelsblatt, a German newspaper. Draghi revealed that there was a higher risk of the ECB being unable to meet Eurozone inflation targets of 2%. Analysts interpreted this as a sign of an upcoming bond-buying stimulus similar to the U.S. QE program.
Draghi’s assessment is probably understated. Eurozone inflation was at a paltry 0.3% in October, continuing a falling inflation trend of over two years. It was last at the 2% mark in January of 2013.
Interest rate modifications have not worked for the ECB. Rates are near zero, and in July 2014, the ECB instituted negative interest rates to provide incentive for banks to lend instead of storing their funds with the central bank. The next logical step for the ECB is increasing the money supply through a bond buyback.
The ECB has a large hurdle, given the convoluted mechanics of buying bonds of individual nations within the Eurozone in a way that is acceptable to all members. The mission of the ECB explicitly discourages the practice, and more prosperous countries like Germany are going to be a hard sell for the purchase of Greek bonds and similar risky issues.
The Euro has already begun its predictable fall, dropping to $1.20 in U.S. dollar value to reach its lowest point since mid-2010. A significant stimulus program could drop the Euro to levels not seen before – perhaps even with the dollar.
It is possible that the mere threat of bond buying will drop the Euro low enough to have the desired inflationary effect, but most analysts expect stimulus to be announced as early as the January 22nd meeting on monetary policy.
The battle is a different one in China, where growth is solid, but slowing. The final growth values for 2014 are expected to be around 7.2-7.3%. While those are enviable numbers for the U.S. and the Eurozone, it represents the weakest Chinese growth rate in almost a quarter-century.
Yet inflation in China is relatively low (currently at 1.4%), well below the government’s target of 3.5% and not predicted to rise above 2% in the near future. This gives the Chinese room for more aggressive actions on stimulus without concerns of high inflation.
Stimulus efforts are addressing both the interest rate and the money supply. An announcement by the central bank that the lending capacity of banks will be increased in 2015 led to a year-end rally in Chinese stocks. The lending capacity increase is through the relaxing of deposit criteria – potentially pumping 5 million yuan (approximately $800 billion) into the system.
Meanwhile, the central bank cut interest rates in November, the first cut in two years. More rate cuts are expected in 2015 to slow the Chinese economy’s descent and stabilize growth.
These worldwide stimulus efforts can be a mixed bag for U.S. interests. Overseas actions are likely to keep the U.S. dollar unusually strong, making our exports less competitive but giving us greater purchasing power for imports.
In the long run, improving economies overseas should provide a stronger market for our goods and keep our economy rolling beyond the momentum of domestic spending – but it may take beyond 2015 before that occurs, especially in Europe.
It took years for the QE efforts in the U.S. to be effective, and one can find spirited arguments about whether it worked at all. Similarly, it is unlikely that a full-fledged bond-buying program in the Eurozone will provide an immediate and lasting economic jolt.
Meanwhile, a strong dollar is likely to continue through 2015, as an eventual rise in U.S. interest rates should combine with overseas stimulus actions to keep U.S. dollars the most attractive currency.
Barring a surprise spike in oil prices or another geopolitical flare-up, worldwide stimulus efforts should keep stocks rising, although at a slowing rate for lack of overseas demand and the stronger dollar putting pressure on earnings. As always, there will be exceptions, and spotting those exceptions can gain (or save) you money.