Monetary policy must stay expansionary

The global economy continues to be held back by slow growth across the developed world. As the International Monetary Fund (IMF) managing director, Christine Lagarde, said on 1 September: "Not since the early 1990s has the world economy been so weak for such a long time".

Although much has been achieved since the global recession of 2009, much more still needs to be done to restore sustainable strong growth, especially in the developed world.

Prolonged weak economic activity has led to an erosion of skills and low productivity growth.

Policymakers continue to debate how best to restore strong growth to the global economy. With official interest rates historically low and negative in some cases, even the IMF has been indicating that perhaps monetary policy is approaching its limits.

VIEW ALL

View all

Others argue that there is actually almost unlimited scope for central banks to engineer greater economic activity.

It is increasingly evident though that monetary policy on its own is not enough and fiscal policy targeted towards upgrading infrastructure would also be desirable in the current environment of low borrowing costs.

Other actions that could be taken to boost demand include "structural reforms". These include labour market deregulation and taking action to reinvigorate trade.

In the case of "creditor countries with policy space", such as Germany, policies to boost domestic demand could add greatly to global growth.

In the developing world, policy prescriptions are similar to those for the advanced economies, including labour market reform, trade liberalisation, infrastructure spending and exchange rate flexibility. The latter would benefit Europe too.

The global economy is growing too slowly and, according to the IMF, could land itself in "a low-growth trap".

"Forceful policy actions" are needed, including structural reform, coupled with expansionary policies.

The very weak US economy

The US economy recorded its third consecutive quarter of very weak growth in the June quarter, pushing back the likelihood of another interest rate hike to later in the year at least.

The major problem, as recently spelt out by a former Fed Chairman, Alan Greenspan, is that private investment in plant and equipment is too low to generate solid productivity growth, which is the key to sustainable economic growth.

Janet Yellen, the current Chair of the Fed, has also acknowledged that the Fed is now carefully scrutinising investment data and understands that this has to improve.

In Greenspan's view, the main problem is the unsustainable rate of growth of government-funded entitlements, growing at none per cent a year.

The other main focus of the Fed and other key policymakers has been the labour market and here the news has been better than for some other economic indicators.

In particular, the unemployment rate has been steady at less than five per cent of the labour force for some months and there is little sign of it rising.

While the housing sector has supported employment for some time, it did show signs of a slowdown in the June quarter, with residential investment and housing prices both down.

Housing affordability though remains good and mortgage rates remain historically low. Also reflecting low interest rates, bank lending to businesses has been strong, as has money supply growth.

Europe growth too weak for too long

Growth in most of Europe, as in the rest of the developed world, has been too weak for too long.

The euro zone as a whole managed growth of only 0.3 per cent in the June quarter, with France not growing at all and even Germany (the beneficiary of an undervalued currency) achieving growth of only 0.4 per cent for the quarter.

The European Central Bank (ECB) has already taken interest rates to zero but it may have to boost quantitative easing (QE) further, while Germany is being urged to greatly lift infrastructure spending.

In the case of Japan, it has not yet responded well enough to expansionary monetary and fiscal policy but it continues to be severely affected by population ageing.

Better news comes from China, where growth is forecast to hold at around 6.5 per cent for this year and next.

Local economy grows solidly

The Australian economy grew at a solid pace in the June quarter.

As well as gross domestic product (GDP) growth, national income growth was also better, reflecting a better outcome for the terms of trade, which have been boosted by stronger commodity prices for some key exports this year, including US dollar price rises of 26 per cent for thermal coal, 53 per cent for oil, and 43 per cent for iron ore from end-January to end-August.

The Australian dollar though rose by over eight per cent against the US dollar over the same period, partly due to its perception as a "commodity currency" and partly due to high local interest rates.

In consequence, our international competitiveness has been affected and the Reserve Bank of Australia (RBA) may need to lower rates again this year.

The July Federal election saw a return of the Liberal/National coalition to Government.

However, the win was extremely narrow and the Party alignment of the Senate looks more adversarial then previously.

In such an environment, the Government may find it hard to legislate for expenditure reductions and it could have to rely on strong economic growth for any real budgetary repair.

According to some forecasts, however, growth could be affected within a year or so by a potential downturn in dwelling construction and a levelling off in resources exports.

This argues for some policy moves, potentially including borrowing at historically low rates to re-build infrastructure.

Monetary policy

The clear message that investors can draw from all of this is that, apart from anything else, monetary policy almost certainly has to remain highly expansionary for some time to come.

This means lower interest rates for longer and, in all probability, even larger QE programs in Europe and Japan.

Even the US Fed, which has been biting at the bit to see interest rates raised, could well have to face the realisation that the ability of the economy to withstand more stringent monetary conditions could still be some way off.

On the other hand, history teaches that when money growth is persistently strong, as in the US at present (where M1 has been growing steadily at a rate of over six per cent a year), eventually inflation usually responds and starts to pick up too.

But there are also novel factors at work in the present environment, including the persistence of deflationary forces out of China, where excess capacity and over-investment in manufacturing capacity and housing has, at least until recently, put downward pressure on prices.

Another factor that is difficult to measure in terms of its economic effect is the steady ageing of most developed societies, with demography having a direct impact on demand.

Given these forces and the pressure for more "forceful policy actions" advocated by the IMF and others, it can be expected that co-ordinated global monetary policy stimulus will probably continue to underpin an upward, although probably volatile, trend in stock markets for some time to come.

While stock markets could be expected to be the main beneficiaries of continued "forceful policy actions" by central banks and governments, even where valuations may be looking rather full, bond markets are also likely to be held up for some time by continued central bank buying as part of the effort to keep global borrowing costs low and thereby stimulate investment and economic activity more broadly.

Conrad Burge is the manager of Fiducian Investment Management Services.