Bigger than the Big 5

October 15, 2009 By Manoj Pradhan When Reinhart and Rogoff compared the US financial turmoil favourably to the five biggest financial crises in industrialised countries in recent years, it was still early 2008. Too early, it turns out, with the benefit of hindsight. Since then, the wake of the financial turmoil and its economic ripples have swept beyond the economic fallout seen in the Big 5 (Spain '77, Norway '87, Finland '91, Sweden '91 and Japan '92) and quite easily past the pains of the last four recessions (Last 4) in the US. Comparing the latest crisis and the ensuing recession with its peers of the past reveals some of the potential pitfalls and policy dilemmas that have yet to be successfully negotiated. First, evidence from the past suggests that crises and recessions are generally followed by benign inflation. Second, policymakers in the Big 5 were able to moderate policy because the risks of deflation had abated, while the Fed was able to depend on a robust recovery in the Last 4. Finally, the experience of these episodes emphasises our long-held view that economic recovery leads to a resumption in lending, but credit and output growth are seemingly locked in a symbiotic embrace thereafter and need each other to post a sustainable recovery. None of these relationships can be taken for granted at the present time, which raises the risks associated with the withdrawal of monetary policy. The transitions in past recessions from a resumption of growth to an entrenched recovery were not without risks. Comparisons with the Big 5 and the Last 4 suggest that downside risks to medium-term growth persist for the current recovery from at least two sources. First, credit may not follow the script laid down by history and may show only a flimsy revival, curbing medium-term economic growth. Second, if growth surprises to the upside in the short term and inflation expectations subsequently rise, policymakers may follow the script laid down by history and tighten policy. This would put the fledgling economic recovery at risk. In a previous note, we have highlighted that the risk of such a premature tightening is the one that seems more likely now that downside risks have abated (see "‘Up' With ‘Swing'?", The Global Monetary Analyst, September 16, 2009). Output and inflation have fallen faster than in the past: GDP and inflation have fallen more sharply and by at least as much if not more than previous episodes in the Big 5 and the Last 4. However, unlike previous crises and recessions, the fall in output and inflation has been mirrored across the globe but the recovery from the recession differs widely from region to region. Our global team continues to expect Asia to outperform the rest of the world, while the G10 is likely to post weak growth. Data out of Latin America have recently shown signs of a robust recovery, but the CEEMEA region remains a laggard, as central banks there have not yet completed much-needed policy easing. For a global economy that saw growth dip into negative territory in 2009, the shape of the recovery in the G10 remains a crucial factor. Economic recovery has come earlier than it did for the Big 5: With US and global economic growth rebounding in 2Q09, the recovery from the current financial and economic downturn has taken longer than the average recession in the US but less time than the average recovery in the Big 5. Clearly, the globally synchronised, aggressive monetary and fiscal policy programmes put into place have helped tremendously in cutting down the recovery time. This policy support is expected to stay in place for a considerable period of time, and therein lies the risk that growth could surprise to the upside over the next few quarters. Central bankers are likely to keep monetary accommodation in place for a significant period, and some have even advised markets that rates will remain low for longer (conditional on inflation, of course). Even where policy rates have been raised early (Israel and Australia so far, with Norway expected to follow this month), the increases are unlikely to be uniform all the way back to neutral. QE programmes in the US and the UK have been extended in scope or maturity time and again and still have a way to go before asset purchase targets are achieved. Finally, fiscal policy packages around the world were typically multi-year programmes that will continue to provide stimulus well beyond the recovery. In the US, for example, Recovery.gov reports that only around US$110 billion of the approved package of US$787 billion (22%) has been spent so far. Monetary policy has been much more aggressive than in the Big 5 or Last 4: The aggressive monetary policy response can be seen clearly in policy rates, bond yields and money growth on a comparative basis. Thanks to rate cuts and QE, the fall in policy rates and bond yields has outstripped those seen in the Big 5 and the Last 4, producing significantly easier monetary conditions. Money supply increased in the Big 5 by nearly 15% on average, but this is still less than the 20% (so far) increase in the money supply under the ongoing QE regime. Crucially, policymakers back then curbed the growth in money supply about a year into the turmoil, which is in stark contrast to our expectations for excess reserves and money supply to continue to grow two years after fixed income markets first froze up. The US$420 billion of QE asset purchases yet to come and the wind-down of the SFP programme together set the stage for an increase in excess reserves held by financial institutions at the Fed from US$918 billion now to about US$1.25 trillion by early 2010, according to our Chief US Fixed Income economist, David Greenlaw. We believe that this will provide continued support for M1 growth. M1 is currently growing at 17%, 15% and 26% in the US, Euro Area and the UK (M1 proxy), respectively, suggesting that economic recovery and asset markets will likely continue to benefit from policy tailwinds. Inflation risks are higher this time round: The size of monetary and fiscal packages along with the declining importance of the domestic output gap in determining domestic inflation are sufficient reasons to be watchful for rising inflation as the economic recovery becomes entrenched. Money supply, when allowed to grow and stay large, has resulted in higher inflation on more than one occasion (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009). In addition, our empirical work suggests the domestic output gap has become less important in determining domestic inflation (see Global Fixed Income Economics: Inflation Goes Global, July 16, 2007). Even if that view is challenged, the size of the domestic output gap remains a contentious issue. The CBO's measure of potential output puts the output gap at approximately -7%, but our own estimates show that the output gap could be as small as -2% due to a sharp fall in potential output. In his academic work prior to joining the ECB, Governing Council member Athanasios Orphanides underscores this issue by pointing out that the errors in estimating the output gap could be as large as the output gap itself. Less leeway on inflation this time round: Policymakers in the Big 5 were able to pull back the strong monetary stimulus because the risk of inflation had abated, while US policymakers could tighten policy because growth had become entrenched and inflation expectations were beginning to rise (see "Growing Pains", The Global Monetary Analyst, September 23, 2009). This time round, central bankers have to contend with inflation risks from global sources, as well as the difficulty in unwinding sizeable QE programmes and raising rates from nearly zero at the right time and speed to prevent inflation risks from being triggered. With little margin for error, the balancing act carries more risks than ever. Recoveries lead lending, but recoveries also need lending: Comparing GDP growth and credit growth shows a wedge between the recovery paths of the Big 5 and the Last 4 versus a similar gap in credit growth between the Big 5 and Last 4 that could account for at least part of the growth differential. Evidence from individual episodes from the Big 5 and Last 4 shows the relationship between output and credit growth quite clearly. As we have argued before, credit growth resumes only after economic recovery has taken place. However, once economic recovery creates favourable conditions for both lenders and borrowers to re-enter the market, robust growth in credit is likely an important ingredient for a sustained recovery. The path of output and credit growth from past episodes suggests that economic recovery tends to be correlated with lending - at least part of this correlation is likely to result from an improvement in credit growth leading to better economic growth. Thus, while we expect credit growth to pick up as the recovery improves borrowing and lending conditions, the risk of weak credit growth weighing down on economic recovery cannot be ruled out. As such, we have highlighted two sources of downside risks for a sustained G10 and hence global recovery. One is the premature withdrawal of policy support if economic growth surprises to the upside and raises inflation expectations, and the other is the downside risk directly from weak credit growth. These two need not be independent of each other - credit growth would also likely suffer if policy were to be tightened prematurely. A volley of speeches from major central banks has argued time and again that they possess all the tools necessary to withdraw the monetary stimulus when required. There is no doubt that they do. What is yet open to question is whether they will be able to deploy these tools to mop up excess liquidity at the right time and with the right speed. Evidence from major crises and recessions in recent economic history suggests that a benign outlook for inflation and rising inflation expectations have played an important role in determining the timing and extent of withdrawal of monetary stimulus. This time round, the tightrope is thinner and much higher above the ground.