Council on Foreign Relations Global Economics Monthly
Issue 8 | January 2014

Global Economics Monthly

Policy Debates for 2014

Robert Kahn, Steven A. Tananbaum Senior Fellow for International Economics

After a year in which U.S. policy dominated the headlines, 2014 should have a more international flavor. Though not predictions, here are five economic themes that could make policymaker's lives difficult in 2014.

1. Catch a Falling Yen

"Abenomics" has rejuvenated growth in Japan, but policymakers elsewhere continue to worry about what it means for the yen. Monetary stimulus—and more specifically the commitment to 2 percent inflation—remains the most powerful of the policy's "three arrows" (the others being fiscal and structural policies), and hopes for easier monetary policy were immediately reflected in a weaker yen. Since December 2012, the yen has fallen 17 percent against the dollar and 13 percent on a trade-weighted basis, with the current rate at 105 yen to the dollar.

While it is possible that the upcoming wage round will provide a durable boost to incomes and inflation, there is growing concern that by mid-2014 the economy could begin to slow and deflationary pressures reemerge. Last month I argued that the Bank of Japan would "do whatever it took" to achieve its inflation target, which in this case means doubling down on its quantitative easing program. Where would that take the yen? A yen-to-dollar rate of 120 or 130 would cause significant stress in finance ministries around the world, given concerns about growth and exchange-rate instability. In addition to a rise in protectionist pressures, the resultant deflationary pulse among Japan's trading partners would intensify incentives for competitive depreciations.

For U.S. policymakers, pressure is mounting from Congress to include exchange rate legislation as part of any trade agreement with Asia (the Trans-Pacific Partnership) or Europe (the Transatlantic Trade and Investment Partnership). A sharp yen decline will intensify this debate. The issue is no less fraught in emerging markets, which are already buffeted by capital outflows over concerns about Federal Reserve tightening. Pressure to impose capital controls or engage in competitive depreciations is likely to mount.

In 2013, the Group of Seven (G7) and Group of Twenty (G20) had a simple mantra: policies should be aimed at domestic objectives, and governments should not purchase foreign instruments (no direct foreign-exchange intervention). It is possible that 2014 will test that consensus.

2. Debalancing and Deleveraging

In the economic context, "rebalancing" is not a pivot in U.S. foreign policy to Asia (at least not explicitly). Rather, it reflects U.S.-led efforts since the fiscal crisis in 2008 to encourage policies that will reduce global economic imbalances, most notably reflected in large current account surpluses and reserve accumulation.

After several years of shrinking imbalances, 2014 looks to be the year that external trade surpluses for China and Germany begin to widen again (see Figure 1). This change reflects growth differentials, in part, and in normal times could be addressed through expansionary fiscal policy or an easing of financial conditions by central banks. But these are not normal times. China's early steps toward market liberalization will be tempered by the need to address the challenge of reining in its shadow banking system, and the risks to imports and growth remain on the downside. Meanwhile, Germany benefits from a euro that, while too strong for periphery countries struggling to restore competitiveness, is much weaker than it would be if Germany were not in a monetary union. A muted recovery in the rest of Europe is unlikely to provide a meaningful counterweight. The region continues to deleverage, and tighter credit conditions in the European periphery are likely to provide a substantial headwind to growth. In this context, concerns about global growth may intensify the rebalancing debate.

Figure 1. German trade surpluses (In billions of Euros)

Source: Haver and Bank of America Merrill Lynch Global Research estimates.

Read more »

Looking Ahead: Kahn's take on the news on the horizon

How Much Taper?

Minutes from the Fed's December meeting will provide needed policy insight as Janet Yellen takes the reins.

Europe Quantitative Easing

The European Central Bank is expected to resist pressures to ease monetary policy in January, but odds are rising for more moves during the first quarter. Ultimately, qualitative easing will be necessary to produce above-trend growth.

Emerging Markets Turmoil

Political turmoil in Thailand and Ukraine, and ongoing concern about capital outflows, appear likely to provide a difficult start to the year in emerging markets.

From the Macro and Markets Blog

U.S. Budget Deal: A Needed Step

Robert Kahn

While the Murray-Ryan fiscal deal doesn't address out critical long-term deficits nor eliminate the possibility of another shutdown, its strides are worth noting and provide something to build on for future debates. Read more »

The Federal Reserve Tapers: In Search of Calmer Waters

Robert Kahn

With respect to the Fed's announcement to taper, here are my comments on implications of market reactions, the Fed's future plans, and global market prospects. Read more »

Shadow of the Sequester

Robert Kahn

I am skeptical that congressional budget conference would produce any deal, much less a grand bargain. Most likely, Congress would fail to find common grounds, instead opting for a continuing resolution for the remainder of the 2014 fiscal year that locks in the sequester level of spending. Read more »

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