Oil price shock
– Alongside ongoing Iran-Israel tensions, the Syrian civil war, a proxy regional conflict between Turkey and the Gulf states on one side and Iran on the other, is spilling over into Lebanon and Iraq. The USA and Russia are backing opposing sides in the region therefore a general middle-east war is possible and may be probable. The resulting oil price shock would have a
deflationary impact on the global economy. While higher food and energy prices may increase
household inflation expectations, in a depressed economy with considerable slack company profits will fall, depressing wages and consumption. Rising import prices and falling or flat export prices would deteriorate terms of trade globally, further reducing demand for goods and services (Seeking Alpha February 2011).
Eurozone crisis – with European banks exposed to stressed eurozone debt markets, a sustained recession increases the risk of a crisis event that destabilises, restructures or ends the euro, contracting global trade in goods and services. In periphery countries the credit contraction looks set to continue as ongoing deleveraging by an over indebted private sector is coupled with fiscal restraint imposed by Maastricht public deficit rules and Germany’s bailout conditions. Fiscal restraint is preventing governments from acting as borrowers of last resort, a necessary role in a liquidity trap if consumer spending is to be stimulated and bank lending revived (INET 2013). For example, Spanish bank lending to the private sector was down 7% year-on-year in May in one of the fastest contractions among advanced economies (Reuters July 15th). Italy’s economy has contracted for 8 consecutive quarters (Business Insider August 6th).
Present policy and therefore the potential for crisis is likely to continue over the near to medium term. The German Constitutional court has ruled that further significant EU integration would require a referendum. Given such a poll would likely be based on the adoption of a new EU treaty, and the Lisbon treaty took five years to negotiate, the Eurozone may have to wait until the 2017 German general election for ‘more Europe’ to finally resolve the crisis, meaning a continuation of the present policy of structural adjustment and little prospect of reversing the negative unemployment trend over the next four years (Bond Vigilantes August 2013; Eurostat June 2013).
Eurozone crisis – with European banks exposed to stressed eurozone debt markets, a sustained recession increases the risk of a crisis event that destabilises, restructures or ends the euro, contracting global trade in goods and services. In periphery countries the credit contraction looks set to continue as ongoing deleveraging by an over indebted private sector is coupled with fiscal restraint imposed by Maastricht public deficit rules and Germany’s bailout conditions. Fiscal restraint is preventing governments from acting as borrowers of last resort, a necessary role in a liquidity trap if consumer spending is to be stimulated and bank lending revived (INET 2013). For example, Spanish bank lending to the private sector was down 7% year-on-year in May in one of the fastest contractions among advanced economies (Reuters July 15th). Italy’s economy has contracted for 8 consecutive quarters (Business Insider August 6th).
Present policy and therefore the potential for crisis is likely to continue over the near to medium term. The German Constitutional court has ruled that further significant EU integration would require a referendum. Given such a poll would likely be based on the adoption of a new EU treaty, and the Lisbon treaty took five years to negotiate, the Eurozone may have to wait until the 2017 German general election for ‘more Europe’ to finally resolve the crisis, meaning a continuation of the present policy of structural adjustment and little prospect of reversing the negative unemployment trend over the next four years (Bond Vigilantes August 2013; Eurostat June 2013).
China hard landing – an overleveraged financial system, a reliance on exports to depressed western consumer markets and political barriers to reform that rebalances the economy towards domestic consumption are significant structural problems that increase the risk of a deflationary crisis. Indicators such as the level of leverage as measured by the domestic credit-to-GDP ratio, asset price inflation in property and land prices, and factors pointing to a structural slowdown in China’s potential growth rate all suggest a correspondence between the country’s financial-risk profile and those of Thailand, Japan, Spain, and the United States on the eve of their recent financial crises. Further policy easing in these conditions would push the leverage ratio and inflation even higher, risking a disruptive and unpredictable deleveraging process, or‘hard landing’ (Nomura, March 2013).
A persistently weakening Yen (see Threats, Stagflation) could also be a factor in triggering a hard landing and a wider emerging market crisis. A falling yen raises China’s real exchange rate with Japan (7% of exports), and negatively impacts ASEAN’s terms of trade with Japan (ASEAN is 10% of China’s exports). With consumer demand in the EU (16% of China’s exports) already depressed, if the US (17% of exports) also tightens policy, deteriorating balance of payments could trigger a currency crisis in China and across the region. In this scenario the use of large FX reserves to prop up currencies adds to the deflationary monetary squeeze, as domestic currency is taken out of circulation. A weakening yen was a causal factor in the 1998 Asian Crisis (Valuewalk, April 2013, Trading Economics/China).
A persistently weakening Yen (see Threats, Stagflation) could also be a factor in triggering a hard landing and a wider emerging market crisis. A falling yen raises China’s real exchange rate with Japan (7% of exports), and negatively impacts ASEAN’s terms of trade with Japan (ASEAN is 10% of China’s exports). With consumer demand in the EU (16% of China’s exports) already depressed, if the US (17% of exports) also tightens policy, deteriorating balance of payments could trigger a currency crisis in China and across the region. In this scenario the use of large FX reserves to prop up currencies adds to the deflationary monetary squeeze, as domestic currency is taken out of circulation. A weakening yen was a causal factor in the 1998 Asian Crisis (Valuewalk, April 2013, Trading Economics/China).
U.S. monetary policy – QE Tapering may signal a shift away from easy monetary policy, increasing deflation risks. Money creation through QE has only partially offset the ongoing contraction of bank credit since 2007-8, preventing deflation but delivering subpar levels of growth (Cato Institute, April 2013). Federal Reserve purchases of mortgage backed securities and treasuries have supported demand for those assets, despite negative real interest rates for much of the period, by preventing falling prices/ rising yields from increasing borrowing costs in those markets and causing a deflationary spiral in the wider economy. In May of this year Bernanke’s announcement of a planned ‘tapering’ of QE over the coming quarters was followed by a hundred basis point rise in U.S. treasury yields. This pushed the national average rate on a 30-year fixed mortgage up to 4.36% from 3.4% on May 1st, risking the recovery in the housing market (Bloomberg July 2013).
To taper, the Federal Reserve is looking for the unemployment rate to fall below 7% and inflation to rise towards 2% - they are 7.4% and 1.8% respectively and presently moving toward target (Bloomberg June 2013, Trading Economics, August 2013). The effect of rising bond yields may delay tapering but if introduced any resulting interest rate impact may be eased by the reinvestment of maturing bond holdings into new asset purchases and a lowering of the Government borrowing requirement due to this year’s sequester and payroll tax rises (Aviate Global June 2013, USA Today February 2013, CNN July 2013). However, if having to begun to taper upward pressure on interest rates were to prompt the Federal Reserve to reverse policy, confidence in the central bank’s ability to implement an exit strategy may erode, increasing the risk of a deflationary interest rate shock.
