Weekly Economic Commentary

Six Questions for 2014

January 3, 2014
by Carl Tannenbaum and Asha Bangalore

View PDF version

  • Six Questions for 2014

For those of you who use the Gregorian calendar, Happy New Year!  Our very best wishes for a prosperous 2014.  For those who focus on the Lunar New Year, the celebration is less than a month away....

Our economic outlook for this year will be available next week.  To provide a taste of what’s ahead, here are some of the key questions we’ll focus on during the coming months.

How fast will the Federal Reserve taper its asset purchases? 

Economic reports from the United States continue to suggest an increasing level of activity; growth for the third quarter was revised up to an annual pace of more than 4%, and forward-looking indicators like the Institute for Supply Management (ISM) purchasing managers index are at very strong levels.  There is a sense of momentum that we haven’t seen in some time.

At his final press conference last month as Federal Reserve chairman, Ben Bernanke hinted that reductions in asset purchases by the central bank could continue at the pace of $10 billion per meeting if economic progress matches expectations.  At that rate, quantitative easing would end sometime this summer.

But if activity exceeds expectations, the Fed could be forced to accelerate its reductions.  While this will be the product of good news (i.e., the economy improving), additional uncertainty over monetary policy could arise.  This could create market volatility.

The assessment of how well the U.S. economy is performing will soon be left to a new Fed chairman – Janet Yellen should be confirmed on January 6 – assisted by a shifting membership on the Federal Open Market Committee.  Anticipating the Fed’s strategy will, therefore, become a bit more complicated.

Increasingly, we are sensing that the bigger risk to our U.S. outlook may be on the upside.  Monetary policy has been extraordinarily accommodative, and if it ever reaches full potency, we could have too much of a good thing.

Abenomics:  Will the third arrow hit the target in 2014?

Japanese Prime Minister Shinzo Abe unveiled three arrows of economic policy in early 2013:
(1) Aggressive monetary policy to ensure the end of entrenched deflation;
(2) A 10.3 trillion yen fiscal stimulus package to lift the pace of economic activity; and
(3) Structural reform to boost Japan’s long-term growth.

Changes in monetary and fiscal policy were implemented swiftly in 2013.  The results of these changes are visible in the economic data.  The trade-weighted yen weakened by close to 18% last year, and equity prices moved up sharply.  Inflation readings normalized, with the November 2013 gain from a year ago at 1.6% compared with a 0.1% drop in all of 2012. 

Mr. Abe’s plans for the third arrow, announced in June 2013, have progressed more slowly.  This is not unexpected; structural reforms are inherently more difficult to implement, both practically and politically.  For example, greater freedom to hire and fire workers represents a break from Japanese corporate tradition.  Changes to immigration, health care and trade policy (among others) will take time to season.

Shinzo Abe’s popularity is high, and he has no opposition in the Diet.  These are big positives that work in his favor.  But the nature of structural reform is complex.  Unlike its two predecessors, the third arrow’s full impact will need to be assessed over a longer period of time. 

Will the U.S. continue to reap a huge energy dividend?

Energy production and energy prices were a major theme in 2013.  American output grew powerfully, and North American prices for oil and natural gas were persistently below those seen in other regions.  

Oil and gas production have been among the strongest sectors in U.S. manufacturing.  The energy price component of the U.S. Consumer Price Index should record a decline in 2013, following a tepid 0.9% increase in 2012.  The question is whether these favorable trends for U.S. growth and inflation can be sustained in the new year. 

The divergence between the Brent crude oil spot price and the West Texas Intermediate (WTI) crude oil spot price largely reflects a lack of infrastructure to transport increased crude oil production.  Pipeline expansions, reduced bottlenecks and a reduction in oil inventories are seen as factors that will narrow the gap between the two oil price benchmarks.  If this forecast is accurate, there will be smaller net benefits to households and businesses in the United States. 

On the supply side, the domestic crude oil production should continue to trim oil imports of the United States, which is the world’s largest producer of natural gas. But unlike crude oil, natural gas is problematic and expensive to export, so world prices vary more.

For the time being the United States has an advantage, but this could vanish as places such as China and Argentina, the two countries with large known shale gas reserves, expand production.  In late 2013, China announced a $13 billion investment in oil and natural gas exploration. 

With respect to crude oil prices, instability among producers like Iran, Libya, Nigeria and Iraq is still high.  More broadly, geo-political rumblings in the Middle East are a source of uncertainty that could be destabilizing.  The region certainly bears continued close monitoring.

Will politics muddy the world’s economic waters? 

The extremes of economic performance within and among nations have given rise to political dissonance over the past several years.  Fringe parties and fringe views seem to be getting greater hearing in a broad range of countries.

Many of those outsiders are skeptical about international cooperation and the traditional conduct of fiscal and monetary policy.  While their points of view are often worthy of consideration, their stridence can make reaching consensus much more difficult.

Aside from the November mid-term elections in the United States,
- Balloting for the European parliament will be held in May;
- India will have national elections in the spring, and Brazilians will go to the polls in the fall;
- Egyptians will be asked to endorse a new constitution; and
- Scotland will contemplate independence.

The potential for important power shifts is significant in several of these instances, which casts some doubt over economic policy and performance.  We’ll try to keep you informed on all these fronts.

Will the Bank of England tighten monetary policy in 2014?

The Bank of England’s (BoE) forward guidance implemented in August 2013 stipulates that the policy rate will remain unchanged at 0.5% until the unemployment rate falls below 7.0%.  The guidance will cease to hold if inflation is forecast to be 50 basis points above the 2% target in the next two years, inflation expectations are unanchored or financial stability is threatened. 

Mark Carney, who took over the BoE’s reins in 2013, adopted forward guidance as a monetary policy tool to support economic activity.  The BoE’s £375 billion asset purchase program and Funding for Lending scheme were put in place before his term.  

To put things in context, the high for the U.K. jobless rate during the recent recession was 8.4% in November 2011.  It had fallen to 7.8% at the time the BoE announced the newly formulated forward guidance.  The U.K.’s September unemployment rate stood at 7.4%.  The rapid improvement in the labor market in such a short time span has raised the question of whether the BoE will consider a higher policy rate in 2014, given that other major economic indicators also send bullish signals. 

Inflation in the United Kingdom, at 2.1%, is down 60 basis points since the current forward guidance was announced but remains above the targeted level of 2%.  Moreover, the improvement in the unemployment rate is not even; there are parts of the United Kingdom with noticeably high rates of joblessness.  Weighing the economic evidence currently available, the odds favor the BoE tinkering with forward guidance for much of 2014 and leaving interest rates alone.

Who will win the World Cup? 

I had the misfortune of giving a presentation to a group of international consultants on December 6.  While I am used to a few participants favoring communications devices over my remarks, I noticed an unusual level of inattention as I began.  Turns out the draw for the World Cup finals had just been released, and the attendees were analyzing the positioning of their home sides.  No speaker can compete with that.

From the middle of June through the middle of July, the economy will take a back seat as 32 national football teams play down to a champion in Brazil.  (That’s soccer, for American readers.)  In fact, worker productivity is expected to diminish significantly during that interval.

The host country is hoping for good results on and off the pitch, assuming it can complete stadium construction without further incident.  Unfortunately, most past hosts have not realized great returns on the investments made in the event.  There is also little correlation between excellence afield and economic achievement.


 
As the father of a college keeper, I pay a great deal of attention to "the beautiful game."  And I am excited by the form of the U.S. side, which recently enjoyed a 12-match winning streak.  But I am also a realist: the Americans have been drawn into a “group of death” from which they are unlikely to emerge.

Seven previous World Cups have been played in the Western Hemisphere.  All seven have been won by a team from the Western Hemisphere.  Five previous tournaments have been won by the host country.  Based on those odds, I’m tipping the seleção to emerge victorious.  And I am hoping that the event doesn’t bankrupt Brazil.

There is no doubt that other questions will arise over the course of the next 12 months.  We will look forward to asking, and answering, as many as we can.
 

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
© 2014 Northern Trust Corporation
Northern Trust - Daily Economic Commentary

Six Questions for 2014

January 3, 2014
by Carl Tannenbaum and Asha Bangalore

View PDF version

  • Six Questions for 2014

For those of you who use the Gregorian calendar, Happy New Year!  Our very best wishes for a prosperous 2014.  For those who focus on the Lunar New Year, the celebration is less than a month away....

Our economic outlook for this year will be available next week.  To provide a taste of what’s ahead, here are some of the key questions we’ll focus on during the coming months.

How fast will the Federal Reserve taper its asset purchases? 

Economic reports from the United States continue to suggest an increasing level of activity; growth for the third quarter was revised up to an annual pace of more than 4%, and forward-looking indicators like the Institute for Supply Management (ISM) purchasing managers index are at very strong levels.  There is a sense of momentum that we haven’t seen in some time.

At his final press conference last month as Federal Reserve chairman, Ben Bernanke hinted that reductions in asset purchases by the central bank could continue at the pace of $10 billion per meeting if economic progress matches expectations.  At that rate, quantitative easing would end sometime this summer.

But if activity exceeds expectations, the Fed could be forced to accelerate its reductions.  While this will be the product of good news (i.e., the economy improving), additional uncertainty over monetary policy could arise.  This could create market volatility.

The assessment of how well the U.S. economy is performing will soon be left to a new Fed chairman – Janet Yellen should be confirmed on January 6 – assisted by a shifting membership on the Federal Open Market Committee.  Anticipating the Fed’s strategy will, therefore, become a bit more complicated.

Increasingly, we are sensing that the bigger risk to our U.S. outlook may be on the upside.  Monetary policy has been extraordinarily accommodative, and if it ever reaches full potency, we could have too much of a good thing.

Abenomics:  Will the third arrow hit the target in 2014?

Japanese Prime Minister Shinzo Abe unveiled three arrows of economic policy in early 2013:
(1) Aggressive monetary policy to ensure the end of entrenched deflation;
(2) A 10.3 trillion yen fiscal stimulus package to lift the pace of economic activity; and
(3) Structural reform to boost Japan’s long-term growth.

Changes in monetary and fiscal policy were implemented swiftly in 2013.  The results of these changes are visible in the economic data.  The trade-weighted yen weakened by close to 18% last year, and equity prices moved up sharply.  Inflation readings normalized, with the November 2013 gain from a year ago at 1.6% compared with a 0.1% drop in all of 2012. 

Mr. Abe’s plans for the third arrow, announced in June 2013, have progressed more slowly.  This is not unexpected; structural reforms are inherently more difficult to implement, both practically and politically.  For example, greater freedom to hire and fire workers represents a break from Japanese corporate tradition.  Changes to immigration, health care and trade policy (among others) will take time to season.

Shinzo Abe’s popularity is high, and he has no opposition in the Diet.  These are big positives that work in his favor.  But the nature of structural reform is complex.  Unlike its two predecessors, the third arrow’s full impact will need to be assessed over a longer period of time. 

Will the U.S. continue to reap a huge energy dividend?

Energy production and energy prices were a major theme in 2013.  American output grew powerfully, and North American prices for oil and natural gas were persistently below those seen in other regions.  

Oil and gas production have been among the strongest sectors in U.S. manufacturing.  The energy price component of the U.S. Consumer Price Index should record a decline in 2013, following a tepid 0.9% increase in 2012.  The question is whether these favorable trends for U.S. growth and inflation can be sustained in the new year. 

The divergence between the Brent crude oil spot price and the West Texas Intermediate (WTI) crude oil spot price largely reflects a lack of infrastructure to transport increased crude oil production.  Pipeline expansions, reduced bottlenecks and a reduction in oil inventories are seen as factors that will narrow the gap between the two oil price benchmarks.  If this forecast is accurate, there will be smaller net benefits to households and businesses in the United States. 

On the supply side, the domestic crude oil production should continue to trim oil imports of the United States, which is the world’s largest producer of natural gas. But unlike crude oil, natural gas is problematic and expensive to export, so world prices vary more.

For the time being the United States has an advantage, but this could vanish as places such as China and Argentina, the two countries with large known shale gas reserves, expand production.  In late 2013, China announced a $13 billion investment in oil and natural gas exploration. 

With respect to crude oil prices, instability among producers like Iran, Libya, Nigeria and Iraq is still high.  More broadly, geo-political rumblings in the Middle East are a source of uncertainty that could be destabilizing.  The region certainly bears continued close monitoring.

Will politics muddy the world’s economic waters? 

The extremes of economic performance within and among nations have given rise to political dissonance over the past several years.  Fringe parties and fringe views seem to be getting greater hearing in a broad range of countries.

Many of those outsiders are skeptical about international cooperation and the traditional conduct of fiscal and monetary policy.  While their points of view are often worthy of consideration, their stridence can make reaching consensus much more difficult.

Aside from the November mid-term elections in the United States,
- Balloting for the European parliament will be held in May;
- India will have national elections in the spring, and Brazilians will go to the polls in the fall;
- Egyptians will be asked to endorse a new constitution; and
- Scotland will contemplate independence.

The potential for important power shifts is significant in several of these instances, which casts some doubt over economic policy and performance.  We’ll try to keep you informed on all these fronts.

Will the Bank of England tighten monetary policy in 2014?

The Bank of England’s (BoE) forward guidance implemented in August 2013 stipulates that the policy rate will remain unchanged at 0.5% until the unemployment rate falls below 7.0%.  The guidance will cease to hold if inflation is forecast to be 50 basis points above the 2% target in the next two years, inflation expectations are unanchored or financial stability is threatened. 

Mark Carney, who took over the BoE’s reins in 2013, adopted forward guidance as a monetary policy tool to support economic activity.  The BoE’s £375 billion asset purchase program and Funding for Lending scheme were put in place before his term.  

To put things in context, the high for the U.K. jobless rate during the recent recession was 8.4% in November 2011.  It had fallen to 7.8% at the time the BoE announced the newly formulated forward guidance.  The U.K.’s September unemployment rate stood at 7.4%.  The rapid improvement in the labor market in such a short time span has raised the question of whether the BoE will consider a higher policy rate in 2014, given that other major economic indicators also send bullish signals. 

Inflation in the United Kingdom, at 2.1%, is down 60 basis points since the current forward guidance was announced but remains above the targeted level of 2%.  Moreover, the improvement in the unemployment rate is not even; there are parts of the United Kingdom with noticeably high rates of joblessness.  Weighing the economic evidence currently available, the odds favor the BoE tinkering with forward guidance for much of 2014 and leaving interest rates alone.

Who will win the World Cup? 

I had the misfortune of giving a presentation to a group of international consultants on December 6.  While I am used to a few participants favoring communications devices over my remarks, I noticed an unusual level of inattention as I began.  Turns out the draw for the World Cup finals had just been released, and the attendees were analyzing the positioning of their home sides.  No speaker can compete with that.

From the middle of June through the middle of July, the economy will take a back seat as 32 national football teams play down to a champion in Brazil.  (That’s soccer, for American readers.)  In fact, worker productivity is expected to diminish significantly during that interval.

The host country is hoping for good results on and off the pitch, assuming it can complete stadium construction without further incident.  Unfortunately, most past hosts have not realized great returns on the investments made in the event.  There is also little correlation between excellence afield and economic achievement.


 
As the father of a college keeper, I pay a great deal of attention to "the beautiful game."  And I am excited by the form of the U.S. side, which recently enjoyed a 12-match winning streak.  But I am also a realist: the Americans have been drawn into a “group of death” from which they are unlikely to emerge.

Seven previous World Cups have been played in the Western Hemisphere.  All seven have been won by a team from the Western Hemisphere.  Five previous tournaments have been won by the host country.  Based on those odds, I’m tipping the seleção to emerge victorious.  And I am hoping that the event doesn’t bankrupt Brazil.

There is no doubt that other questions will arise over the course of the next 12 months.  We will look forward to asking, and answering, as many as we can.
 

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
 
©2014 Northern Funds
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