Global Growth Forecasts - Seeing is Believing?

I reckon it must be quite tough at the moment to be an analyst or a money mover/manager. This is not only because of difficult markets and a very opaque economic outlook, but more so because as we move into year's end we are flooded by a veritable tsunami of sell and buy side research  on the big themes of 2009 and those to come in 2010. Naturally, we should be able to deal with such information overflow without much difficulty, but still; the amount of incoming pages of, often very interesting, research is massive.

Now, we can add another to the list in the form of the latest quarterly review from BIS which is a whopper of a publication filled with interesting articles, data, and charts. I have just scanned the "overview" and thus only scratched the surface but still, and in case you have spent the last 6 months on a beach, the first 10 pages provide a nice summary of a Q3/Q4 of 2009 dominated by an outright risky asset rally as well as a rebound in economic activity driven by especially stimulus (and inventories) and the expectation that favorable policies will stay in effect well into 2010. They do mention Dubai, and while I agree that this was indeed significant I think we defer the importance of this for the time being since risky assets seem, for now, to have shrugged off the implications.

From early September to late November, a steady stream of mostly positive macroeconomic news reassured investors that the global economy had in fact turned around, but investor confidence remained fragile. This was clearly illustrated towards the end of the period under review, when prices of risky assets dropped sharply as investors reacted nervously to news that government-owned Dubai World had asked for a delay in some payments on its debt.

Market participants expected the recovery to continue, but at times grew wary about its pace and shape due to uncertainty about the timing and speed of withdrawal of monetary and fiscal stimulus as well as the associated risks to future economic activity. The unease was compounded by the unevenness of the recovery among different regions of the world, which in turn was seen as increasing the risk that harmful imbalances could build, thereby adding to challenges for policymakers. In this environment, market developments continued to be driven to a significant degree by ongoing and expected policy stimulus, and in particular by expansionary monetary policy. As investors priced in expectations that interest
rates in major advanced economies would remain low prices of risky assets continued to go up. Equity prices generally rose, in particular in emerging markets.

Now, this is all well and good of course and while most of the charts and graphs passed by without further notice as I scrolled down the pages one in particular caught my glance.

You see, in my capability of a part time analyst for a small consultancy shop I also have to perform a rudimentary forecasting exercise of GDP for the major economies of the world.  Today I did just that and as I really don't have time to develop an inhouse econometric framework to produce quarterly GDP forecasts I simply average over a number of big ticket research houses' forecasts (e.g. Citi, Soc Gen, Nomura, BNP etc) [1]. And wouldn't you know it, the graphs which sprung from my excel sheet looked very much like the ones above.

So my main question is.  Do we really think this is a plausible outcome?

In my own report I found myself tying my argument up in knots qualifying and hedging my analysis to reflect the fact that only in the best of all possible worlds will be allowed to simply move on into a V-shaped recovery. Especially, and while I have no problem accepting the idea that emerging economies may continue to exhibit impressive growth rates, the story in the advanced economies will be different. Growth will be lower than before and in some cases it will be outright zero or negative for an extended period. In fact, it strikes me as quite odd that we are able to produce such forecasts when the data tells us that conditional on a withdrawal of stimulus the world is bound to look very different.

Allow me to offer just a few examples in the form of the very real risks of "double dip" recessions in Japan and in Germany as well as the mounting issue, not of if, but when we will see the next major sovereign default. On the latter point, Greece finds itself in the eye of the storm at the moment, but this is really a much more structural issue and as it becomes abundantly clear that ongoing fiscal deficits cannot be maintained for ever, growth will plummet in key economies and further exacerbate the structural problem. I mean, what you only have to do at this point is to pick Greece, Spain, the US etc and then substract the boost from government and monetary stimulus. What would be the growth rates you come up with. Well, in so many words, they would be grim! This is naturally precisely why policy makers have acted as they have but to use a well worn market metaphor; at some point the cyclical boost will have to give way for a structural recovery and thus as the proverbial tide rolls back, we will see who forgot to put on their swim suits (or who did not have money to buy one in the first place). In fact, the distinction between cyclical and structural factor are important now more than ever and even though this is basic market/economy research 1-0-1, it is worthwhile remembering it anyway. Tim Duy provides a timely example on how to master this distinction in the context of the US economy in his recent Fed Watch (hat tip: Mark Thoma).

In terms of the global forecast, I can only say that once we break the numbers and outlook down to its core it becomes clear that we are in a much more shaky position than current sentiment suggests.

But, for now seeing, it seems, is indeed believing.

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[1] Sssh ... don't tell our client this

An Overview of Unconventional Monetary Policies

The excellent research edifice at the Bank of International Settlements have conjured up one of those papers which needed to be written (by Claudio Borio and Piti Disyatat) on the back of the myriad of different monetary policy responses we have observed in the contex of the economic crisis. The abstract and conclusion look as follows;

(my emphasis throughout)

The recent global financial crisis has led central banks to rely heavily on “unconventional” monetary policies. This alternative approach to policy has generated much discussion and a heated and at times confusing debate. The debate has been complicated by the use of different definitions and conflicting views of the mechanisms at work. This paper sets out a framework for classifying and thinking about such policies, highlighting how they can be viewed within the overall context of monetary policy implementation. The framework clarifies the differences among the various forms of unconventional monetary policy, provides a systematic characterisation of the wide range of central bank responses to the crisis, helps to underscore the channels of transmission, and identifies some of the main policy challenges. In the process, the paper also addresses a number of contentious analytical issues, notably the role of bank reserves and their inflationary consequences.

(...)

In the wake of the current financial crisis, monetary policy will probably never be the same again. Central banks have been forced to review their implementation frameworks and to try out policies that, only a few years back, were not on their radar screens. They have been operating in unchartered waters, outside their “comfort zone”. In the process, unconventional monetary policies have become the focus of much discussion and heated debate. In this paper, we have provided a unified framework to think about and classify unconventional monetary policies, considered the analytical issues they raise, with particular reference to the transmission mechanism, and briefly assessed some of the key policy challenges.
We have stressed several analytical points.

First, unconventional monetary policies fall under the broader category of balance sheet policy, whereby the central bank uses its balance sheet to affect asset prices and financial conditions beyond the short-term interest rate. Thus, they are not unconventional in their essence, with foreign exchange intervention being a very familiar form of such policies.

Second, balance sheet policies can be decoupled from interest rate policies. This reflects the fact that the level of the short-term interest rate can be set independently of the amount of bank reserves in the system. Third, the main channel through which balance sheet policy operates is by altering the composition of private sector balance sheets, exchanging claims that are imperfect substitutes for each other. By altering the risk profile of private portfolios, such as through the purchase of less liquid or risky assets or by being prepared to lend at more attractive terms than the markets, the central bank can reduce yields and ease financing constraints.

Fourth, because of this, in our view the outsized role often attributed to banks’ excess reserves in discussions of balance sheet policy is not warranted. Since excess reserves are very close substitutes with short-term claims on the central bank or the government, what the central bank buys and the credit it extends are more important than how these operations are financed. Finally, balance sheet policy should be the considered in the broader context of the consolidated public sector balance sheet. Importantly, central banks have a monopoly over interest rate policy, but not over balance sheet policy.

While we have not examined in depth the effectiveness of balance sheet policies, it would be hard to deny that they have helped to stabilise conditions and cushion the fall in aggregate demand. There is evidence that central bank purchases of government bonds have lowered their yields, although they seem to be subject to “diminishing returns”, once the surprise factor wears off. And policies targeting interbank markets or private sector securities have been successful in narrowing risk spreads and supporting borrowing activity there.

At the same time, balance sheet policies raise a number of challenges for central banks. As central banks move away from the simplicity and well-rehearsed routine of interest rate policy, they face much trickier calibration and communication issues. As they substitute for private sector intermediation, they may favour some borrowers over others, tilting the level playing field, and could risk making the private sector unduly dependent on public support. As they purchase government debt, they come under pressure to coordinate with the public sector debt management operations. And as their balance sheets expand and they take on more financial risks, central banks risk seeing their operational independence and anti-inflation credentials come under threat in the longer term. As a result, questions about coordination, operational independence and division of responsibilities with the government loom large. These costs suggest that unconventional monetary policies should best be seen as special tools for special circumstances. The costs also point to the need for appropriate governance arrangements, designed to limit the risk that the central bank anti-inflation priorities are undermined in the medium term. And they put a premium on early exits, as soon as economic conditions permit.

I have only scanned the paper and thus not really given it the attention it probably deserves, but one of the things I found most interesting, (especially in the light of the my recent inquiry into the matter with respect to the ECB), is that while I agree that exit strategies is first and foremost a communication exercise they will also become a concrete operational challenge.

More generally, the discussion on the transmission channel from unconventional monetary policy as split into two between the signalling channel and the broad portfolio channel (operational/market channel) is interesting and provides a good framework through which to understand the current initiatives by monetary policy makers. The paper also pulls out the classic, as it were, about how the Fed and the ECB differs in their response because the former has focused extensively on the non-bank sector (asset backed securities and government bonds) whereas the latter has mainly focused on the the banking sector (i.e. through fixed-rate full-allotment refinancing operations with maturities of up to 12 months).

Again, it is difficult to argue with the underlying argument here in the sense that it is clearly borne out in the data. The problem with the ECB, as I have argued before, is the extent to which banking finance is indirectly funding the purchase of government bonds and thus what happens to sovereign spreads in the Eurozone when the refinancing offers taper off into 2010. That is a subject for a different entry. For now, I leave you with this instructive paper from the BIS; it is well worth a look.