2 July 2014
Domestic and external environment
Global financial markets have remained calm as the US Federal Reserve continued the reduction of its large-scale asset purchase programme. Monetary policy paths of major advanced economies look set to diverge in the face of varying domestic economic conditions. In the US, growth has been halted temporarily by the severe winter weather and inventory reduction but the underlying momentum of the recovery remains intact. In the euro area, the recovery has remained subdued with disinflationary pressure continuing to persist. In Japan, strong growth has been driven by the frontloading of domestic demand and the economy faces the risk of a sharp reversal. In East Asia, growth momentum of many economies has generally moderated, with real GDP growth in Mainland China receding in the first quarter on deceleration of both external and domestic demand. In Hong Kong, the economy grew slowly in the first quarter largely due to sluggish trade performance, while high-frequency data continue to suggest modest growth momentum more recently. Loan growth has moderated in recent months, but the credit situation continues to warrant close monitoring and supervision, particularly in terms of banks’ funding risks and credit risks.
Global financial markets have remained calm amid expectation of a prolonged period of accommodative monetary policy and improved growth momentum in advanced economies. Monetary policy paths of major advanced economies look set to diverge with strengthening recoveries in the US and the UK bringing forward expectations of interest rate hikes while risks of weakening growth in Japan and persistently low inflation in the euro area have prompted expectations of further unconventional monetary easing. In the US, growth was halted temporarily by the severe winter weather and inventory destocking but the underlying momentum of the recovery remains intact. Excluding inventories and net exports, final sales to domestic purchasers grew by 1.6% in the first quarter, the same pace as in the previous quarter. The unemployment rate fell to 6.3% in May, down sharply from 7.5% a year earlier, although much of the improvement was driven by a fall in labour force participation. The recent rebound in activity indicators and the run of robust employment growth suggest the economy should improve vastly in the second quarter. Similarly in the UK, the economy continued to strengthen with real GDP growing by 0.8% quarter on quarter in the first quarter following a solid 0.7% growth in the previous quarter. The recovery has broadened out with production, construction and services all expanding in the quarter. The number of people in work also hit a record high with the unemployment rate falling to a 5-year low of 6.6% in the three months to April. In contrast, economic recovery in the euro area has remained subdued with real GDP growing slowly by 0.2% quarter on quarter in the first quarter, down from 0.3% in the previous quarter. The ongoing balance sheet adjustment and the stubbornly high unemployment rate continue to weigh on the recovery. As a result, disinflationary pressure persisted with the annual inflation rate falling to 0.5% in May and many peripheral countries sliding into deflation which exacerbated their debt problems. In Japan, the economy grew strongly by 1.5% quarter on quarter in the first quarter, driven by the frontloading of domestic demand to beat the tax increase in April. The economy now faces the risk of a sharp reversal of the frontloading demand in the second quarter, and the strength and sustainability of the subsequent recovery in the second half of the year remains uncertain.
Major central banks look set to embark on diverging monetary policy paths in the face of varying domestic economic conditions. In the US, the solid recovery means the Fed continued to reduce its large-scale asset purchase programme by another $10 billion to $35 billion per month in the June Federal Open Market Committee meeting. The Fed previously hinted that the asset purchase programme could end in autumn with the possibility that it could be followed by the first rate hike in around 6 months. As the unemployment rate has been falling faster toward its numerical policy threshold than projected, the Fed has switched from quantitative to qualitative forward guidance and widened the metrics in their “dashboard” of economic and labour market data. Similarly in the UK, the faster-than-expected fall in the unemployment rate means the Bank of England (BoE) has switched from a numerical-threshold based forward guidance to a qualitative guidance that is based on a wide range of economic indicators. Both the Fed and the BoE have stated that interest rates will likely be kept below their longer run levels even when employment and inflation get close to their targets. In Europe, the European Central Bank (ECB) announced a package of monetary easing measures in the June Governing Council meeting, including in particular cuts in key policy interest rates and the introduction of Targeted Longer-Term Refinancing Operation (TLTRO). At the same time, the ECB Governor Mario Draghi emphasized the ECB has not exhausted monetary easing options by saying that “if needed, within our mandate, we aren’t finished here”. In Japan, the Bank of Japan (BoJ) has so far stuck firmly to its Quantitative and Qualitative Easing programme (QQE) by doubling its JGB holdings and meeting its base money target during the first year of implementation. The BoJ Governor Haruhiko Kuroda has said repeatedly that the central bank is ready to strengthen the QQE programme if the economy slows more than expected after the tax hike in April.
On the fiscal side, advanced economies look to have made some progress with fiscal consolidation. In the US, the Congressional Budget Office has revised down its forecast for current year (FY2014) fiscal deficit, to 2.8% of GDP in April, down from 3% in February and below the past 40-year average of 3.1%. In the euro area, countries have continued their fiscal consolidation effort although the pace has started to slow and there is still a long way to go. In Japan, the government has finally started fiscal consolidation in FY2014 to meet its long-term goal of achieving a primary fiscal balance by FY2020. Consumption tax was raised from 5% to 8% in April 2014, and the Japanese government is planning to increase it further to 10% in October 2015.
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