The Continental Economics Institute’s Financial Market Snapshot
September 3, 2013
by Antony Mueller
Economic growth and monetary conditions
The period of relative tranquility on the international financial markets over the past couple of months is ending. Major changes have already taken place, many more are about to happen. In the United States, the American central bank is about to end its monetary policy of quantitative easing. The effects of this change have already led to a shift in international capital flows. Money moves out of the emerging markets. This way not only the Brazilian real has weakened, but devaluation also hit hard the Indian rupee. In Europe, the announcement of its “Outright Monetary Transactions” program by the European Central Bank (ECB) last year has tranquilized financial markets and lowered the risk perception of international investors of the creditworthiness of the European crisis countries. Growth is picking up in the United States and in Japan. Over the past couple of years, the major central banks have swamped the globe with liquidity. If economic recovery should continue, a new tough job already awaits central bankers: how to avoid worldwide inflation.
There are signs that the super cycle in commodities is not yet over. There is little reason to expect the oil price to fall. On the contrary, the tensions in the Middle East are rising. Conflicts that are even more violent seem inevitable. This way oil and gold are set for rebound. Other commodities will benefit when global economic recovery will continue. There are signs that Europe is moving out of its slump and that the United States and Japan are back on their growth paths. Latest figures of the Brazilian gross domestic product indicate the end of the economic downturn of this country. The Chinese hunger for natural resources is still unbroken. With these demand factors well in place and given the immense liquidity overhang in the financial markets, the failure by central banks to curb excessive monetary growth can rapidly transform into a wave of price inflation.
One of the good signs over the past couple of years has been the fact that the international economic and financial crisis has not provoked protectionist measures. Except by some leaders of emerging economies, there has been no threat of protectionism among the major industrialized countries. Even in the face of persistently high trade deficits, the United States did not bring up protectionism. Nevertheless, the global macroeconomic constellation has remained unsustainable. It cannot go on forever that China and other Asian emerging economies as well as countries like Brazil and other emerging economies will continue to finance the American trade deficit in its present dimensions. The problem with postponed necessary adaptations is that these eventually tend to take place in vehement and uncontrolled manner.
The monetary policy of the past couple of years with its extreme expansion of the monetary base comes back now to haunt central bankers for years to come. Solid economic recovery is under threat because the gigantic liquidity overhang threatens price stability. Much earlier and stronger than otherwise - if there had not been a monetary expansion - central bankers will now have to raise interest rates in order to avoid price inflation. Soon we may hear from the policy makers that it was due to their action that the recovery finally has come. They will assert that the threat of price inflation is a completely different matter with no link to earlier monetary policy. In reality, however, things are quite the opposite of what these statements will say. Not only would economic recovery have come much earlier without central bank intervention, the return to economic growth would also not have to face the risk of price inflation as it does now because of the excessive creation of central bank liquidity over the past couple of years.