2017 Outlook – The return of inflation is no reason to party

The Trump administration may embark on an experiment in fiscal policy loosening in an economy that is already operating at full employment. This presents the risk of a boom-and-bust cycle, although not in 2017. Global growth will be strong next year, despite the modest slowdown in the Euro zone and China. Inflation will rise, partly due to rising oil prices…..


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Paradoxically, inflation could prove destabilising if it obliges the ECB to stop purchasing securities. A comprehensive European strategy on public debt is needed, but the election cycle of 2017 and the growth of populism are complicating the scenario.

Constant complaints about the lack of any active fiscal policy may have been answered by the election of Donald Trump as United States president. In fact, the next president has confirmed that he plans to work with Congress to implement a drastic cut in corporation and personal income tax. Even assuming that the plan will be less aggressive than previously announced and that some of the effects will be cancelled out by an increase in the propensity to save (high or very high earners will benefit the most), it could nevertheless lead to more rapid US GDP growth from the second half of 2017, and particularly in 2018. Our projections for the US economy do not include a radical change in fiscal policy at this time, as we prefer to wait for more concrete evidence before finalising a revision of the forecasts (which, moreover, could pertain more to 2018 than to 2017). The consensus estimates for 2017 are also still relatively stable, at 2.22.3%. Even graph D on page 4 does not yet reflect a possible change in fiscal policy, and might, therefore, suggest a tighter orientation in fiscal policy at global level than will actually be seen next year.

It is unfortunate that fiscal stimulus is coming to a country that has little need for it, as it already has very low levels of unemployment. The surprise result of the US election has given fresh impetus to inflation forecasts incorporated in market prices, including European forecasts. For now, the increase is not likely to alarm the central banks (the 5-year inflation rate implicit in the swap curve rose from 2.0% to 2.5%), but it certainly eliminates one of the factors that have so far held back the normalisation of monetary policy rates. On reflection, it gives more credibility to the Federal Reserve’s guidelines on official rates, which this year – rightly, with hindsight – the market has quietly ignored, and has produced a significant increase in the slope of the yield curves. In Europe, the ECB has announced a further extension of the securities purchase programme to December 2017, although the reduction of the monthly volume from EUR 80Bn to EUR 60Bn has, nevertheless, brought the cessation of this extraordinary support into the forecasting horizon. The most serious problem that might be created by an ill-timed fiscal stimulus is the emergence in the US of the risk of a boom-and-bust cycle, increasing the likelihood of excess inflation, followed by a recession due to monetary tightening.

I spoke of the “acceleration”, rather than the “start” of a rise in forecasts, because the process began in October, before Trump was elected, prompted by signs of improvement in global economic activity, rising oil prices and rumours of a cut in OPEC oil production. The prospect of oil prices remaining at least at these levels in 2017 (see the comment on pages Y-Z) will allow average inflation in the OECD countries to return to 2%, after two years under 1%, although in other countries the increase in underlying inflation will continue to be curbed by global excess capacity. It is difficult to predict how long the current positive economic period will last. Since November, the economic data have provided positive surprises in all areas – particularly in the Eurozone. According to the PMI survey, growth in manufacturing activity and in services is again accelerating (see graph A on page 4), and global GDP growth is gradually rising, after the lows at the start of this year. This improvement reflects several parallel processes, relating to the Euro zone, China, the United States and countries producing raw materials (particularly oil). Increased growth in the US and the oil-producing countries is likely to extend into 2017. Meanwhile, the Eurozone will experience conflicting pressures: on the negative side, a loss of household purchasing power due to the rising prices of energy commodities; and on the positive side, a probable upturn in exports and business investment. Fiscal policy will be in no way expansionary, but neutral at most. Even though China’s economy has performed better than expected in recent months, it continues to be overshadowed by financial imbalances. Weighing the various factors involved, we believe that the slowdown in Europe and China will be modest, and that global growth should pick up again next year.

Many have complained about the low level of inflation in recent years. Paradoxically, however, the attainment of inflation targets in the Eurozone could create many more problems in the future than in the phase of zero price growth, because of the very high level attained by public debt in many countries. The problem no longer exists in Japan, where the central bank has pledged to continue its purchases of government securities even if inflation returns to target, and where a deliberate and aggressive strategy of debt monetisation is therefore being implemented. In the Eurozone, however, if inflation were to return to 2%, the constraints set by the ECB Statute and the differing visions afflicting the Governing Council would make it nearly impossible for the ECB to continue the purchase programme much beyond December 2017. And if the programme ends in 2018, the share of Italian or Portuguese public debt that is “sterilised” because it is transferred to the budget of the national central bank will still be too small to affect the sustainability of the debt in any decisive way (at the end of 2017, only 20% of debt in the 2-30 year range for Italy, compared with a massive 41% for Germany). For issuers with the worst fundamentals, the rise in debt refinancing costs could then more than offset higher nominal GDP growth, also because the markets could soon return to discounting some break-up risk.

In this scenario, a stricter application of the Stability and Growth Pact would not help at all. The framework of rules on fiscal policies is confusing, overly complex and based on the erroneous assessment that it is possible to eliminate excess public debt by increasing the primary surplus to sufficiently high levels. It should be radically reformed, but a credible reform should also include a strategy for managing excess public debt inherited from the past. That cannot be an outright restructuring, because it would break the financial system. The good news is that a strategy to reduce debt servicing that involves neither a further deterioration in living standards, nor costs for the other Member States, does exist: it is an enhanced PSPP, which has already been tested and has no adverse effects worth mentioning. However, we will have to contend with the rules established for another historical context and unsuited to the current situation, and with the political dynamics that characterise the European Union in this period. In fact, the imminent launch of negotiations to take the UK out of the EU and the rise of populist parties in many Member States (see the analysis published last week) is leading us ineluctably towards a minimalist interpretation of the role of the Union and maintenance of the status quo, due to a lack of consensus about which direction to take. Taking an optimistic view, after the 2017 elections European governments could decide to take the bull by the horns and remove the threat of debt, in order to regain some room for manoeuvre. This would require some legal inventiveness and the cooperation of the Eurosystem: but when political will is imposed, no formalism can resist it. Pessimists might object to this on the grounds that next year’s elections will return governments that are even more concerned with internal political dynamics and are hostages to populism, and therefore reluctant to discuss strategic questions. So let’s hope that the pessimists are wrong.


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