International Economic Update: Low Inflation and Slower Medium-Term Growth Accompany Uneven Recovery
May 9th, 2014
by Valerie Grossman and Enrique Martinez-Garcia - Globalization and Monetary Policy Institute, Federal Reserve Bank of Dallas
World (excluding the U.S.) economic growth stood at 3 percent year over year in fourth quarter 2013, with the gap between advanced (excluding the U.S.) and emerging economies narrowing to 1.6 percentage points—the smallest growth differential since fourth quarter 2002. Headline consumer price index inflation for the world (excluding the U.S.) stood at 3.3 percent year over year in March 2014, running slightly ahead of core inflation (2.8 percent year over year).
The outlook is largely unchanged in recent reports, with world economic activity projected to grow 3.6 percent in 2014 and 3.9 percent in 2015, according to the International Monetary Fund’s April 2014 World Economic Outlook. The expected growth uptick is supported by the firming of the advanced economies’ recovery, but concerns remain about lower-than-expected inflation in advanced economies and slower medium-term growth in both advanced and emerging economies.
Euro Area’s Low Inflation Prompts ECB to Consider Monetary Easing
The euro area’s 0.5 percent headline inflation is well below the European Central Bank’s (ECB) target of “below, but close to, 2 percent,” raising fears of a period of low inflation or deflation (Chart 1). Given high unemployment, slack and pressures from low import prices in the euro area, inflation could keep falling. The perceived risk is that sustained deflation could lower inflation expectations and push the real interest rate higher than required to maintain growth at potential, adversely impacting economic activity. ECB President Mario Draghi stressed that medium-term inflation expectations remain firmly anchored, but added that recent low readings were a “genuine surprise.” Draghi indicated that there was unanimity among the ECB Governing Council members on using unconventional tools, if needed—“there was a discussion of [quantitative easing] QE” (Chart 2). Other major advanced economies have pursued monetary accommodation through unconventional tools to provide additional support to their economies.
Recent short-term indicators point to continued strengthening in the euro area. For instance, the flash Purchasing Managers Index for manufacturing rose to 53.3 in April. However, robust growth over the medium term and unwinding of slack—which could contain downward pressures on inflation—depend on improving potential growth and dealing with structural problems (objectives that are probably not best attained with monetary policy). The European Commission’s latest estimates for euro-area potential suggest that slack may decline and inflation could begin to rise if the cyclical recovery continues as expected in 2014–15. The commission’s estimates do not anticipate an increase in potential growth that would lead to a more robust expansion over the medium term (Chart 3).
Temporary Factors Buoy Japan’s Inflation
Unlike most other advanced economies, Japan has experienced steadily increasing inflation since 2013. However, the Bank of Japan’s 2 percent target may not be fully incorporated into long-term inflation expectations (Chart 4). The recent bout of inflation may be partly due to temporary factors. On April 1, the value-added tax (VAT) was raised from 5 to 8 percent, which affects roughly 70 percent of the consumer price index. Core inflation is at its highest level since 1997, the last time Japan increased its VAT. Headline inflation is running ahead of core, buoyed by the significant depreciation of the yen in 2013 and rising imported energy costs due to the nuclear plants’ closure following the Fukushima disaster (March 2011). Japan is expected to restart its nuclear reactors, contingent on safety inspections, in late 2014.
After its policy meeting on April 7–8, the Bank of Japan maintained its current pace of easing and retained in its policy statement that the economy “has continued to recover moderately.” An expected rush to make purchases before the VAT hike could boost first quarter 2014 growth, but weak economic activity is likely for the rest of the year. Trade data also indicate that net exports may be a significant headwind. Despite the drag on growth, the VAT hike is a step toward fiscal consolidation—Japan’s debt burden was estimated at 228 percent of GDP in 2013, 146 percent net of financial assets—with most of the revenue raised slated for debt reduction.
Tightening Cycle in Emerging Economies on Pause
Since early 2013, some emerging economies have tightened their monetary policy in response to recurring episodes of currency stress and capital outflows. This tightening seems to have paused in March, as these earlier risks and fears about China’s slowdown partly materialized. While the mood appears to have shifted, a few emerging economies have continued to tighten. Brazil’s central bank raised its Selic interest rate from 10.75 percent to 11 percent on April 2 in an attempt to contain inflation caused by drought-related food price increases. Colombia’s central bank announced a surprise 25 basis point hike on April 28. Russia and Ukraine also tightened in response to the ongoing Ukrainian crisis. At the same time, emerging economies are still adjusting to lower medium-term growth prospects (Chart 5). Little progress has been made to address domestic and external vulnerabilities.
China’s Sluggish Growth May Compromise Long-Term Objectives
China’s real GDP growth for first quarter 2014 announced on April 15 stood at 7.4 percent year over year, down from the previous quarter’s 7.7 percent and below the official annual target for 2014 of 7.5 percent. People’s Bank of China (PBOC) Governor Zhou Xiaochuan stated that China was prepared to act with “fine tuning or stronger measures”—but clarified that those would only be needed if growth strayed too far from target.
Recent policy actions suggest a shift is already underway toward a more accommodative stance to cushion the slowdown while refraining from large-scale stimulus and maintaining the pace of incremental reforms. For instance, in February 2014, the exchange rate shifted from appreciation to depreciation ahead of a widening of the renminbi (RMB) trading band, and interbank interest rates were lowered after being allowed to remain elevated for some time (Chart 6). On April 22, the PBOC reduced required reserve ratios for certain rural banks as part of support measures for the agricultural sector. Modest increases in fiscal spending for social housing and rail construction have also recently been announced. Fears about China’s ongoing slowdown have arisen partly from concerns about its medium-term growth prospects, even if cyclical factors may temporarily be dragging growth down too. Hence, the risk is that fine-tuning policies and short-term considerations may take precedence over long-term objectives, especially if growth continues to slide.
Risks Remain, but Moderate Growth to Continue
Signs of strengthening global growth emerged in 2013, as improvements in the advanced economies outweighed the continued slowdown in emerging economies. World economic activity is expected to pick up in 2014, but the balance of risks remains to the downside. While some risks have attenuated or abated (fears about removal of monetary accommodation in the U.S., uncertainty about the European banking union, and currency stresses and tightening in some emerging economies), other risks have appeared or become more prominent (low inflation and slow potential growth in advanced economies, slowdown in China, weaker medium-term growth prospects in emerging economies and worsening Ukrainian crisis).
- Data reported in this international update for the aggregates—world (ex. U.S.), advanced (ex. U.S.) and emerging—come from a representative sample of 40 of the largest economies ranked by their importance as trading partners of the U.S. See “Database of Global Economic Indicators (DGEI): A Methodological Note,” by Valerie Grossman, Adrienne Mack and Enrique Martínez-García, Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute Working Paper no. 166, December 2013. For the methodology used for dating global cycles, see “A Contribution to the Chronology of Turning Points in Global Economic Activity (1980–2012),” also by Grossman, Mack and Martínez-García, Globalization and Monetary Policy Institute Working Paper no. 169, January 2014.
- The data are not directly comparable as the IMF uses a broader selection of countries and somewhat different country groupings than DGEI, but the patterns we observe are consistent.
- For advanced economies (close to or at the zero floor on policy rates), we look at a quantitative-based measure—central bank’s total assets (as percent of 2007 GDP)—as proxy for the monetary policy stance. An increase in the central bank’s balance sheet would signal monetary easing.
- A second value-added tax increase (to 10 percent) is scheduled for late 2015.
- China’s recent steps toward financial liberalization include the widening of the renminbi’s (RMB) intraday trading band against the U.S. dollar around its daily fixing and the People’s Bank of China’s agreements with the Bank of England and the Bundesbank to establish RMB clearing and settlement in London and Frankfurt. The trading band for onshore RMB (CNY) at +/–0.3 percent replaced the dollar peg on July 21, 2005, was later extended to +/–0.5 percent with the U.S. dollar on May 21, 2007, widened to +/–1.0 percent on April 16, 2012, and to +/–2.0 percent on March 17, 2014.
About the Authors
Grossman is a research analyst and Martínez-García is a senior research economist in the Globalization and Monetary Policy Institute at the Federal Reserve Bank of Dallas.