The monetary tug of war

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The FINANCIAL — The next year is likely to see an extraordinary tug of war between the major central banks in the developed world. The US Federal Reserve and Bank of England intend to raise interest rates. The Bank of Japan is already an enthusiast for quantitative easing. The European Central Bank (ECB), faced with excessively low inflation, is likely to be converted to the cause by early 2015.

Some forecasters seem confident the US and UK economies are now enjoying sustained recoveries, that Abenomics will eventually revive Japan, and the ECB can avoid outright deflation. But this conclusion may prove too complacent.

Japan showed that exiting from zero interest rates is not easy. Its strengthening economic activity at the end of the 1990s was less a sign of nascent recovery and more a reflection of the global technology boom. And when boom turned to bust, the Bank of Japan’s decision in August 2000 to raise interest rates almost instantly looked foolish.

No central bank is in control of the overall macroeconomic environment. There are a number of immediate concerns.

First, the recovery from the global financial crisis remains remarkably soft, even in countries doing better than average. Second, the inflationary process remains highly uncertain: price rises in the developed world have routinely exceeded forecasts, suggesting complacency about deflationary pressures.

Third, despite Russian sanctions and political tensions in the Middle East, many commodity prices have dropped a long way, consistent with still very weak credit growth. Fourth, even where unemployment has declined rapidly – most obviously the US and UK – wage growth remains muted, again consistent with surprisingly low inflation.

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There is also a potential risk of major currency upheavals. Think, for example, of sterling’s surge in 2004 – when the Bank of England was raising rates even as the Fed was still cutting – or the yen’s 2012 decline, predicated on expectations that the Bank of Japan would eventually respond to political pressure by turning on the printing press.

A strong dollar, fuelled by higher US interest rates, will likely expose vulnerabilities in other parts of the world. Latin American countries already flirting with recession would certainly not welcome tighter US monetary conditions. China would have to consider its ongoing willingness for the renminbi to appreciate against a strengthening US currency, particularly if it is heading into another domestic ‘soft patch’. Other Asian countries would be caught between higher US interest rates and a weaker yen.

We have lowered our 2015 growth projections in the emerging world from 5.1 per cent to 4.9 per cent, in part reflecting these increased monetary risks. The biggest disappointments are Brazil – cut from 1.2 per cent to 1 per cent – and, thanks to sanctions and related political uncertainty, Russia, where we now expect a 1 per cent contraction rather than 1 per cent growth.

Our forecast for India, with a more stable monetary footing and the promise of Modi-led reform, has been raised to 6.6 per cent and 7.3 per cent in 2016. China’s growth should be 7.7 per cent in 2015.

For the developed world, we expect 2.6 per cent US growth in 2015 but Japan is proving to be a major disappointment and we have reduced our forecast to 1 per cent. Eurozone growth also trundles along at around 1 per cent.

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