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Macro Research

December 12, 2013

Finnish Macro Forecast

Recovery despite structural headwinds

Global economy: Central banks on divergent tracks

Eurozone: Heading for deflation?

Finland: Recovery despite structural headwinds

Monetary policy and FX: Policy shifts bode for a USD rally

Contents

Global economy Central banks on divergent tracks 4

Eurozone Heading for deflation? 8

Finland Recovery despite structural headwinds 12

Monetary policy and FX Policy shifts bode for a USD rally 15

Key ratios 19

Disclaimer 21

Contact information

Tuulia Asplund, +358 10 444 2403, [email protected]

Tiina Helenius, +358 10 444 2404, [email protected]

Jan Häggström, +46 8 701 1097, [email protected]

Petter Lundvik, +46 8 701 3397, [email protected]

Finnish Macro Forecast, December 12, 2013

4

Global economy

Central banks on divergent tracks

The global monetary policy landscape has seen diverging tendencies this year, with rate hikes in several

emerging economies while the ECB has cut rates and the Bank of Japan and the US Federal Reserve have

pursued aggressive quantitative easing. Next year, policies in developed countries will be on diverging tracks,

with the Fed starting to move towards less accommodative policies, while the ECB will be on the opposite

tack. Sweden and Norway are more likely to follow the Fed than the ECB.

One of the themes of recent Macro Forecasts has been the divergence of economic out-

looks. The implication has been that monetary policies face very different challenges across

the globe. Rising inflationary pressure has already produced monetary policy responses in

many emerging economies and has also been a factor in the reluctance of the People’s

Bank of China to add stimulus this year and the willingness to accept a stronger renminbi.

That has held back the strength of recoveries in emerging economies.

The challenges facing the central banks in Western Europe, the US and Japan have been

rather similar up until now, but that is gradually changing. The US is leaving many problems

behind, supporting a shift in Fed policy, which we think is imminent. If monetary policy is left

in place for too long in a recovering economy, there is a risk that new bubbles start to form.

The UK has surprised favourably this year, leading markets to price in rate hikes in the not

too distant future. In Japan, the aggressive monetary policy put in place a year ago has

helped push inflation upwards, but the Bank of Japan has to keep buying government bonds

to prevent interest rates from rising. The ECB is years behind and needs to focus on pre-

venting deflationary tendencies and help mend the dysfunctional eurozone credit market.

In the Nordic countries, Denmark is probably still happy to keep very low interest rates to

help household finances and real estate markets recover. Finland is still in a weak recovery

and credit growth is trending down, so the country will likely not find it problematic for some

time that the ECB keeps rates close to zero. Norway and Sweden are different. Recoveries

from the great recessions were relatively strong; low interest rates have contributed to

booming housing markets and rising household debt. Inflation is still well below targets in

both countries, but both central banks forecast rate hikes within a year.

We argued earlier this autumn that rate hikes in Sweden next year are very unlikely unless

the Fed starts to signal hikes and help the dollar appreciate versus the euro and the Swed-

ish krona. Unilateral rate hikes in Sweden would probably strengthen the currency too much

and wreak havoc on the Riksbank’s forecast of inflation returning to target. If we are right

about the Fed next year, we will likely also see the Riksbank diverge from ECB and Bank of

England policies.

Emerging economies

fighting inflation and

currency appreciation

A three-way fork in

the road

Two camps in the

Nordics

Sweden waiting for

US action


5

Will the Fed spoil the party again for emerging markets?

As the US labour market continues to improve, conditions will soon be in place for the Fed to

start scaling down its monthly purchases of treasuries and mortgage bonds. We look for that to

happen within the coming months. Towards the end of the year, the US economy will most

likely not need ultra-low rates either. That shift will probably be signalled well in advance, fol-

lowing the communications policy adopted by the Fed under Chairman Ben Bernanke.

When Bernanke started to talk in late May about the likelihood that the Fed would start ta-

pering asset purchases within the next couple of FOMC meetings, it came as a big surprise

to most market participants. Readers of our Macro Forecast should not have been surprised,

as we wrote a year ago that such a signal from the Fed was likely to come before the sum-

mer of 2013. Bernanke’s comments in May were not a slip of the tongue, we think, but were

probably intended both as a guide on where Fed policy was heading and as a trial balloon to

see the impact of the policy change signal on financial markets.

The Fed’s view on the impact of bond purchases has been that the effect comes as the pro-

gramme is announced rather than at the time when it is executed. The market reaction to Ber-

nanke’s talk about the end of tapering seemed to confirm that view, as bond yields rose

sharply in the following weeks. The negative term premium, as we estimate it (see our Global

Macro Forecast from August 2013 for details), switched to positive and approached the aver-

age level seen during the five years preceding the start of the Fed’s QE programmes.

The FOMC’s decision on September 18 came as a surprise and bond yields fell back again,

but not by as much as they had risen since May. That would seem to be a logical response,

as the Fed only postponed the start of tapering. Consequently, we do not expect a new ma-

jor leap upwards for bond yields once the Fed actually starts to reduce purchases. Rather,

we see a gradual rise in yields as markets start to prepare for the next shift in Fed policy,

which will be rate hikes.

But what about emerging markets? Those experienced a dramatic reaction in May after

Bernanke started to talk about tapering: currencies fell in tandem with stock markets. At the

Kansas Federal Reserve conference in Jackson Hole, central bankers and leading politi-

cians from emerging economies voiced concern that the Fed did not pay attention to the

impact outside the US of changes in monetary policy. Will we see a repeat of all of that once

the Fed actually starts to move? Will money once again rush out of emerging markets?

We are not so certain. First of all, causality is not so clear. If Bernanke’s tapering talk was

the real reason for emerging market currencies and stock markets falling, why did they re-

cover again in late summer yet developed world bond markets did not? Some would say that

is because the FOMC chose not to start tapering on September 18. But the problem with

that line of reasoning is emerging market currencies and stocks turned around almost one

month prior to the Fed meeting. Were they more forward-looking than the US bond market,

which was taken by surprise on September 18? That is hardly likely.

Tapering likely to

start in the coming

months - really

Impact of bond pur-

chases comes on an-

nouncement

Emerging markets

hit by investor exo-

dus at first tapering

announcement…

…but this is unlikely

to happen again

http://research.handelsbanken.se/Attachments/19934/Global%20Macro%20Forecast%2029%20august%202013.pdf

http://research.handelsbanken.se/Attachments/19934/Global%20Macro%20Forecast%2029%20august%202013.pdf


6

One plausible explanation is that there were other factors at work, provoking first a decline

and then a recovery for emerging markets. For instance, China started to deliver data that

were worse than expected in May. That would be important for many emerging economies,

especially those selling commodities to China, such as Brazil and Indonesia. In August, Chi-

nese economic data started to turn better than expected. That happened to coincide with

recoveries in emerging market currencies and stock markets. So there are factors other than

the Fed that might explain why emerging markets started to underperform in May and also

why they started to perform better again in August, well before we knew that the Fed would

not start tapering in September.

There is also a second reason why we are not so sure that emerging markets will be so

sensitive once the Fed’s policy shift occurs. The emerging market turmoil in May and June

served to highlight underlying problems with inflationary pressures and lack of reform. Cen-

tral banks in many cases responded by tightening monetary policy to hold back inflation,

helping bring investors back to those markets and boosted their currencies. So credibility for

monetary policy in emerging markets seems to have returned.

However, discussions about the need for structural reforms have also intensified. We cannot

be so sure about the results. Two of the big emerging economies in Asia, India and Indone-

sia, also have elections before the summer, making the outlook for structural reforms still

uncertain. Opinion polls indicate that more reform-oriented politicians are advancing. It

would seem that the market unrest in early summer, for whatever reason it came, was a

warning bell to politicians in emerging economies and one can only hope that it leads to an

increased focus on necessary reforms.

A shift in Fed policies would help the eurozone avoid deflation

There are several reasons why there are deflationary risks in the eurozone. Historically-high

unemployment, especially in the south, is a major factor pushing down wages and prices. It

will take a long time to bring unemployment down to levels where those downward pres-

sures disappear. We do not think that rising inflation in Germany and possibly a few smaller

economies in the eurozone will be enough to offset deflationary tendencies elsewhere.

The ECB is trying to speed up the eurozone recovery but rate cuts do not always help when

households, firms and governments are all trying to consolidate their finances. The weak-

ness of banks, especially in the south, is another reason why low policy rates are not stimu-

lating credit growth. Making banks stronger must be part of the recipe for keeping deflation-

ary risks at bay, but it might take another year before there is any action on this front.

Inflation in the eurozone has also been held back by the appreciation of the euro. The gen-

eral price level in the eurozone relative to the US and other trading partners has risen this

year. If the euro rises further, deflationary pressures are likely to intensify, so a weaker euro

would be a welcome contribution to reduce risks for deflation.

Weak Chinese data

likely hurt in May

Emerging market

monetary policy

credibility is back

Structural reforms a

hot topic

Weak banks…

…and strong EUR,

slow recovery


7

Short-term interest rates in the eurozone and the US moved in tandem during 2013, but,

even so, the dollar has weakened versus the euro. One of the reasons might be the simulta-

neous expansion of the Fed’s balance sheet and the contraction of ECB’s. An end to QE in

the US and some kind of move towards expanding the ECB’s balance sheet might thus help

reverse euro strength. Signals from the Fed of a change in rate policy would probably

strengthen the dollar versus the euro. We forecast a large decline in the euro next year (see

separate article) for this very reason, so the ECB should not have reason to complain if the

Fed shifts towards less accommodative policies. The longer the Fed delays tapering or the

start of rate hikes, the bigger is the risk of deflation in the eurozone.

Global GDP forecasts, percentage changes

Source: Handelsbanken Capital Markets


Handelsbanken’s Gobal Macro Forecast is available in its entirety at http://research.handelsbanken.se/Macro-Research/.

2012 2013F 2014F 2015F

USA 2.8 1.7 2.7 2.9

Eurozone -0.7 -0.5 1.0 1.1

United Kingdom 0.1 1.3 1.5 1.7

Japan 2.0 1.9 1.5 1.2

Russia 3.4 1.6 2.5 2.9

China 7.8 7.6 7.3 7.0

India 5.1 4.7 5.0 5.5

Brazil 0.9 2.5 2.5 3.0

No complaints from

the EU if the Fed

gets accommodative

mailto:[email protected]

http://research.handelsbanken.se/Macro-Research/


8

Eurozone

Heading for deflation?

A surprise drop in October inflation forced the ECB’s hand. Risks of deflation must be taken very seriously

when the policy rate is close to zero. The eurozone is now in a similar bind as Japan has been in for many

years. The price level relative to main competitors is too high but the currency refuses to weaken, so the

domestic price level has to adjust downwards instead. Unlike Japan, unemployment is very high,

contributing to deflationary tendencies. Consequently, we expect the ECB to ease monetary policy further

while the Fed moves in the opposite direction, so a substantial decline in the euro will help prevent deflation.

The eurozone economy bottomed out before the summer, but growth did not accelerate ma-

terially in the third quarter. Sentiment indicators have disappointed a little in recent months,

suggesting that the recovery will remain sluggish. We look for around 1 percent GDP growth

in 2014, implying that growth rates continue around 0.2-0.3 percent per quarter. The upside

is limited by several factors. Weakness in the banking sector is holding back the supply of

credit and the need to reduce debt burdens the private sector, holding back demand. The

ECB’s rate cuts will not do much to stimulate either credit supply or demand, except in

economies that are not saddled with bank or debt problems.

The need for fiscal consolidation is also a factor for weak recoveries in many countries. Fol-

lowing the recommendations from the IMF last autumn, European leaders agreed to hold off

from budget cuts while economies were in recession. As a result, there have been very lim-

ited budget improvements. That will come back to haunt governments now that economies

are recovering.

The budget problems are most acute in Spain, where the central government deficit so far in

2013 is actually larger than in the previous year, despite the implementation of budget cuts and

tax hikes in the second half of 2012. For the Spanish regions and local communities, we only

have data for the first half of 2013, but that is not a pretty picture either. The European Com-

mission now forecasts that the general government deficit in Spain will remain around 6-7 per-

cent of GDP in 2014-16, even though it expects an economic recovery. One of the reasons is

that some of the tax hikes implemented in recent years were temporary and will expire.

That puts the Spanish government in a very awkward position in the run-up to the general

elections in the autumn of 2015. But the alternative, to let deficits keep on running, risks put-

ting Spain in a similar position as Italy, which has a government-debt-to-GDP ratio well

above 100 percent. That would necessitate even tougher budget cuts later on in order to

reach higher primary surpluses. Otherwise, the budget situation would spin out of control.

We look for around 1

percent GDP growth

in 2014

European leaders

agreed to hold off on

budget cuts

Budget problems

most acute in

Spain...


9

The need for budget cuts also looms large in many other eurozone economies. Even if fiscal

austerity is deferred, the general public knows that they will eventually be hit, which is con-

tributing to holding back consumer spending. It also makes for a situation where political

support for governments remains weak. In France, President Hollande is plumbing new

depths in opinion polls. His policy proposals are met with protests from left and right, farmers

and entrepreneurs. Whether that is a factor behind the recent declines in economic senti-

ment indicators is hard to tell, but government policies certainly do not seem to be helping

the recovery.

The upcoming EU parliamentary elections in May will present an ideal opportunity for voters

to show their discontent with current policies. That overlaps with a period when important

decisions need to be taken about a banking union. As a consequence, there could be re-

newed market tensions. The current calm in bond markets is partly the result of the ECB’s

policies and commitments, but it also reflects no real disturbances to the political process

aiming at a banking union. The big hurdles on that front still lie ahead.

How big are the deflationary risks?

Surprisingly-low inflation numbers in October were one of the factors triggering the ECB rate

cut. Several eurozone countries are already in negative territory, most notably Greece,

where inflation is currently -1.9 percent. Spain just dipped below the zero line on core infla-

tion, but the underlying deflationary tendencies were masked by the VAT hike last year tem-

porarily lifting consumer prices. Both countries have massive unemployment, so downward

pressures on wages is likely to persist for a long time, contributing to falling unit labour

costs, weak income growth and weak domestic demand.

...but budget cuts

also needed in many

other eurozone

economies

New flare-up of mar-

ket tensions?

Greece in deflation,

Spain also dipped

below zero


10

Germany faces the opposite situation. Unemployment may decline to below 5 percent in

coming quarters, which is certain to put upward pressure on wage costs and prices. The

recently-agreed minimum wage will also contribute to rising inflationary pressures. The

pockets of upward pressures on wage costs and prices are probably too small presently to

offset the downward pressures elsewhere. The ECB did the right thing by cutting the policy

rate, but more needs to be done in order to reduce the risk that the eurozone aggregate

ends up in deflation. There is not much room left to lower policy rates, but there is a lot of

room to push down borrowing rates for households and firms, especially in the weaker

economies. Gaps between bank lending rates and the ECB policy rate have widened in

many countries due to the weakness of their banks.

There is not that much the ECB can do about the financial fragmentation of the eurozone

other than to support efforts to create a functioning banking union. Low funding costs for

banks will certainly help banks’ profits. But an important offsetting factor is that returns on

bank assets will continue to be depressed by write-downs for bad debt. When and how a

banking union will be implemented is still uncertain, so it is unlikely to have much of an im-

pact in the short term on financing conditions in the countries facing deflationary tendencies.

Consequently, the negative impact from bank weakness on employment and domestic de-

mand is likely to persist.

However, the ECB can still make an impact on the general deflationary tendencies for the

eurozone. The exchange rate is an important factor influencing the relative price level be-

tween the eurozone and the rest of the world. The lesson from the UK since 2009 and Japan

during the past year is that quantitative easing can have a dramatic impact on the currency.

For the UK and Japan, a falling exchange rate led to rising import prices and an upward

push for consumer prices. The immediate impact on inflation from currency depreciation is

much larger than the impact from a monetary policy expansion on inflation via higher aggre-

gate demand.

We have argued in previous macro research reports that persistent deflationary tendencies

in Japan were a reflection of the fact that the currency, and consequently the relative price

level, got stuck at too high a level. If relative price level depreciation cannot take place via

the exchange rate, it has to come about via a lower relative rate of inflation. With very low

rates of inflation in the US and Europe, inflation in Japan had to turn negative. Please note

that throughout the long period of deflation, Japan did not really have big slack in the labour

market: the rate of unemployment has been relatively low.

The situation in the eurozone is now similar to Japan’s situation in the years before the big

monetary policy shift started to push down the yen a year ago. That analogy is relevant for

the eurozone relative to other economies and for individual countries within the eurozone.

The euro has remained strong and the price level is too high. Unless the currency drops

sharply, inflation has to be pushed down relative to other countries and the eurozone as a

The ECB did the

right thing by cutting

policy rate, but more

needs to be done

Still uncertain when

and how banking

union will be imple-

mented

Lesson from the UK

and Japan: QE can

have a dramatic im-

pact on the currency

Eurozone now in a

similar situation to

where Japan was...


11

whole might thus end up in deflation. But between countries in a monetary union, exchange

rate adjustments are by definition impossible, which explains why wages and prices have to

fall in the countries that need to restore their competitiveness – unless they rise in Germany,

of course.

Unlike Japan, the eurozone has large slack in the labour market. Stripping out Germany,

where unemployment may soon lead to higher wage inflation, the unemployment rate in the

eurozone is close to 15 percent, a record-high by a wide margin. Including Germany, unem-

ployment is just over 12 percent, which is also a record. In 2014 and 2015, we do not think

that unemployment will fall by very much, so the deflationary force will remain. The IMF, in

its October economic outlook, actually forecast that the eurozone will not fall below 10 per-

cent in 2018, so downward pressure on wages and prices will be in place for a very long

period unless the ECB acts aggressively.

If the ECB were to undertake some kind of QE and/or the Fed winds down QE and starts

hiking rates, the euro is likely to drop against the US dollar and other major currencies. That

is actually our forecast (see separate article). Moreover, once markets begin to expect Fed

hikes, rates will also move in favour of the dollar versus the euro. Therefore, it is not our

main scenario that the eurozone will find itself in a long period of deflation. But our assump-

tions for the ECB and the Fed, or the exchange rate impact of a shift in relative monetary

policies, could turn out to be wrong, so deflation risks remain. In our view, the ECB is al-

ready paying close attention to those risks and will adjust policies accordingly. We will wit-

ness an extended period of low ECB rates, possibly into 2018, and the ECB is also likely to

adopt measures to expand its balance sheet. That will reduce deflationary risks for the euro-

zone as a whole, but downward pressure on prices and wages in the countries riddled with

mass unemployment are likely to persist.

Key forecasts for the eurozone, percent



2012 2013E 2014E 2015E

GDP growth -0.7 -0.5 1.0 1.1

Inflation 2.5 1.5 1.6 1.7

Unemployment rate 11.4 12.3 12.2 12.1

...but eurozone also

has high unemploy-

ment, so downward

pressure on wages

and prices set to per-

sist unless ECB acts

aggressively

We forecast that

EUR will drop vs.

USD and other cur-

rencies


12

Finland

Recovery despite structural headwinds

As domestic fundamentals remain weak and fiscal austerity continues, the strength of the recovery depends

on external demand. We see encouraging signs, but structural headwinds limit the pace of GDP growth.

The Q3 GDP statistics were a negative surprise, in our view, as the GDP stagnated while we

had expected it to grow. However, we see Q3 as the bottom of the business cycle and believe

that a gradual recovery is starting in Q4. Nevertheless, GDP volume will contract y-o-y in 2013

for the second consecutive year and we have lowered our GDP forecast for 2013 to -1.2 per-

cent. We expect the timing and strength of the recovery to depend on foreign demand, as do-

mestic fundamentals are too weak to initiate domestic demand-driven growth. We therefore

look for the economic recovery to be moderate compared to earlier upturns. Our estimates for

GDP growth in 2014 and 2015 are 1.5 percent and 2.2 percent, respectively.

Key forecasts for Finland


Structural challenges limit the scope for export led recovery

There have been recent signs of moderately strengthening sentiment and growth in many

important export markets. Measured by the value of goods exported, Finland’s three most-

important export markets are Sweden, Russia and Germany, in that order; we expect growth

to strengthen in those economies during 2014-15. Due to structural supply-side problems in

Russia, its growth is unlikely to provide Finnish exports a lift as sizable as before the finan-

cial crisis. All in all, we expect the export recovery to be modest compared to previous up-

turns due to structural change in Finnish industries. However, the remarkable weakening of

the euro should support export activity especially in 2015, in our view.

Percentage change y-o-y 2011 2012 2013F 2014F 2015F

Private consumption 2.6 0.2 -0.5(0.5) 0.7(1.0) 1.3(1.7)

Public consumption 0.5 0.6 -0.8(0.7) 0.2(0.5) 0.2(0.5)

Investment 5.7 -1.0 -2.7(-2.5) 1.7(3.5) 5.0(5.0)

Exports 2.8 -0.4 -0.3(-1.3) 4.0(4.6) 6.5(4.5)

Imports 6.2 -1.2 -2.1(-3.5) 2.2(3.0) 5.4(4.2)

GDP 2.7 -0.8 -1.2(-0.2) 1.5(2.0) 2.2(2.2)

Earnings 2.7 3.2 2.1 1.7 1.4

CPI 3.4 2.8 1.5 1.6 2.2

Unemployment rate* 7.8 7.7 8.1 8.1 7.8

General govt balance, % of GDP -0.7 -1.8 -2.1 -1.7 -1.0

* % of labour force

SHB's forecast from September in parentheses

We estimate Finnish

GDP to contract 1.2

percent y-o-y in 2013

Russia unlikely to

boost Finnish

exports in 2014e


13

As the share of manufacturing electronic products and electrical equipment to total value-

added manufacturing shrank from 25 percent in 2000-08 to less than 8 percent in Q2 2013

and the global investment cycle remains too modest to support demand for the engineering

sector, paper, pulp and paperboard products have regained their status as the most impor-

tant export product group (16 percent share of total goods exported value in January-

September 2013). Machinery and equipment’s share has decreased to 13.4 percent, while

coke and petroleum products’ share has increased to 12 percent, to a level above basic

metals’ 11.7 percent share. The trend of lower value-added intermediate goods, crude mate-

rials and fuels increasing their export shares, while manufacturing and exports of higher

value-added goods struggle, is worrying. Although awareness of this challenge is increasing

among the political and economic elite, there are few ways to rapidly restructure the indus-

trial base. Uncertainty about the export and growth outlook therefore remains a moderating

factor to corporate investment growth in 2014e-15e.

Household sentiment and finances gradually improve towards 2015

Low confidence and stagnating purchasing power (thanks to lower employment and higher

taxes) have led households to be wary. Consumer price inflation decelerated steeply during

2013, but deflation is not a threat, so lower inflation is welcomed to compensate for the

moderate two-year wage deal recently agreed on. Taxation is set to rise further in 2014, as

taxes on alcohol, tobacco, soft drinks, electricity and fuels are increasing and many local

governments plan to lift tax rates. Furthermore, cuts in public spending will have both direct

and indirect effects on purchasing power and consumption. We expect private consumption

growth to remain relatively modest in 2014, but better sentiment, a stronger labour market

and low interest rates should give a boost to private consumption growth in 2015e.

The labour market has been weak throughout 2013: employment and the labour force con-

tracted by 1.1 percent and 0.6 percent y-o-y on average between January and October. Busi-

ness surveys now indicate that the worst fall in employment is probably over, but none of the

main employer sectors expect increasing employment. The pace of contraction will instead

likely be more moderate in coming months. Despite the delayed economic recovery, we mar-

ginally lower our 2013 unemployment rate forecast, to 8.1 percent. Leakage from the labour

force has restrained the increase in the unemployment rate more than we had expected. We

look for the unemployment rate to remain unchanged in 2014, at 8.1 percent. In 2015e, the

strengthening business cycle should pull the unemployment rate down to 7.8 percent.

Construction of new residential and non-residential buildings remained in the doldrums this

year, but residential activity has been supported by repairs and renovations, which are nec-

essary given the ageing residential building stock. We do not expect construction activity to

pick up until 2015. A slowdown in housing loan stock growth following increased risk aware-

ness of consumers and lenders, higher loan margins and increased transaction costs point

Uncertainty over the

export and growth

outlook to moderate

corporate investment

growth in 2014e-15e

Tax hikes keep pri-

vate consumption

growth relatively

modest in 2014e…

…but a boost is felt

in 2015e from low

rates, improved sen-

timent and a

stronger job market

Surprisingly strong

leakage from the

labour force

Tight supply in

growth centres likely

to prevent steep

house prices declines


14

to continued moderation in housing demand, but tight supply in growth centres is likely to

anchor house prices from serious downward corrections.

Closing the sustainability gap is a main priority of fiscal policy

The current coalition government’s focus is on closing the sustainability gap of the public

sector by 2017, estimated to be roughly EUR 9 billion, or 4.7 percent of GDP, according to

the Ministry of Finance. The government plans to cover more than half of the gap by cutting

local governments’ expenditures, by improving their productivity and reducing their tasks

and obligations. The six-party government introduced some of the planned measures to

achieve these savings in late November, but many important reforms – such as the restruc-

turing of social and health services – are still under preparation process. Furthermore, more

than a third of the sustainability gap is expected to be covered by lengthening working ca-

reers and reducing unemployment, but restructuring of the pension system is still under ne-

gotiation by labour unions and employer organisations. The plan is to prepare the needed

legislative changes concerning the pension system already during this government’s term,

but the decisions will be made during the next electoral period, which starts in the spring of

2015. The current plan is to implement the pension system reform by 2017.

The structural reform programme is under way, but its success depends on whether the am-

bitious plans will be fully implemented and whether the schedule will hold. The next parlia-

mentary election taking place in less than 18 months is putting pressure on the current gov-

ernment. Despite the fragmentation of its base, the government seems united in keeping

Finland’s AAA credit rating.

The centralised wage deal will slow growth in public expenditures in 2014e-15e and the

business cycle recovery will support the revenue side, leading to a lower deficit and a slower

build-up of debt. We expect the public debt to GDP ratio to rise to 59.3 percent in 2014, but

to decrease marginally, to 58.9 percent, in 2015.

Tuulia Asplund, +358 10 444 2403, [email protected]

Tiina Helenius, +358 10 444 2404, [email protected]

Many important

parts of the struc-

tural reform package

are still under prepa-

ration process

Government seems

united in keeping

Finland’s AAA credit

rating


15

Monetary policy and FX

Policy shifts bode for a USD rally

Monetary policy has not reflected fundamental economic conditions in the US or the eurozone, in our view.

However, that seems to be about to change in a direction that supports the USD versus the EUR. We expect

the USD to appreciate by more than 15 percent versus the EUR in the next 12 months.

USD to strengthen on differences in economic conditions…

We expect differences in economic conditions and policy between the US and the eurozone

to sharply strengthen the USD versus the EUR. Our forecast is that the EUR/USD rate will

hit 1.10 within twelve months and parity within twenty-four months. At present, US GDP is 6

percent higher than its pre-financial-crisis level, while the average q-o-q growth rate for the

first three quarters of 2013 is 2.2 percent in annualised terms. The corresponding numbers

for the eurozone are much worse. The level of GDP is 2.4 percent lower than before the

crisis, while the average annualised growth rate for 2013 is 0.2 percent. The unemployment

rate is 7.0 percent and declining in the US versus 12.2 percent and likely still not at its peak

in the eurozone. Moreover, deflation risks are much higher in the eurozone.

…but also due to differences in financial conditions

Credit to non-financial businesses, a fundamental factor for economic growth, is currently

expanding in the US and contracting in the eurozone. In the past 12 months, the debt-to-

GDP ratio for those businesses increased steadily in the US but declined in the eurozone.

The difference in credit demand of course is an important reason, but structural factors are

also important. In general, US banks are in good shape, while banks in the eurozone are

undercapitalised. Moreover, monetary policy in the US is still much more expansive than in

the eurozone. The real policy rate is lower, but in addition, the policy rate relative to nominal

GDP growth is also lower.

In the middle of 2009, household debt was elevated relative to GDP. Since then, it normalised

sharply in the US but declined only modestly in the eurozone. Consequently, in the eurozone,

deleveraging will likely continue to weigh on growth, while in the US, residential construction is

already an economic driver, as households are leaving debt problems behind.

Data-dependent Fed to taper in coming months

The FOMC has frequently stated that monetary policy is data-dependent and that forward

guidance, including thresholds to start hiking rates, is not a binding commitment. Thus, at

every meeting the Committee is free to make the appropriate policy decision regardless of

previous guidelines and market expectations. Moreover, the Committee is well aware that

the past three recessions have been caused by financial exuberance and that the seeds of

USD to strengthen

sharply vs. the EUR

on differences…

…in economic condi-

tions…

…and in household

debt

Past three recessions

due to financial exu-

berance


16

the next recession are likely already planted in financial markets. At the moment, hardly

anyone believes that the next recession will be prompted by high inflation and the Fed’s

tightening policy to cool the economy. Consequently, searching for information about exces-

sive risk taking or any other form of exuberance is probably a top priority at the Fed.

The costs of the current asset purchasing programme are likely rising as the Fed’s asset

holdings increase. In our view, the Fed should stop all further asset purchases as soon as

possible. Financial markets tend to see them as a Fed put – the idea that the Fed will arrest

increases in bond yields1 by raising the pace of its asset purchases or postponing rate hikes.

That implicit Fed guarantee is lowering the price for risk and encouraging excessive risk-

taking. At present, complacent investors are focusing more on how much longer the current

monetary policy regime will last and what mix of policy tools the Fed will use in the future

than on the real economy. However, belief in a Fed put is likely an illusion, especially on a

longer horizon. Investors will eventually have to face the real risks of their investments,

which could lead to sharp selloffs of risky assets and a substantial rise in the price for risk.

That is a scary scenario that has the potential to rock the economy. Moreover, a Fed put

could result in a serious misallocation of capital, as it implies that the pricing of risk does not

reflect true risks or even perceived risks. Too much capital could be allocated to risky finan-

cial investment, crowding out productive real-economy investment.

Sub-par US recovery

The Fed’s aggressive policy response to the financial crisis of 2007-08 likely prevented a

really deep economic contraction. Bernanke has often stated the importance of massive

monetary accommodation to arrest feedback-driven downward sloping spirals that could end

in a 1930s-like depression. The longer a large output gap persists, the more permanent

damage is done to the supply side of the economy and to the working-skills of long-term

unemployed people in particular. According to him, the implication is straightforward. Eco-

nomic policy should be as aggressive as possible in order to minimise the loss of potential

output in the long run. However, Bernanke has driven that perspective to an extreme. In an

unprecedented experiment to fight unemployment, an exceptionally expansive monetary

stimulus has been maintained much longer than ever before.

Fed officials claim that the prevailing monetary policy is working, as, according to them, the

output gap is primarily due to weak aggregate demand. However, we have for some time ar-

gued that the decidedly weak recovery and persistent high unemployment are partly due to

structural factors and not only to cyclical ones. Consequently, boosting aggregate demand by

only monetary measures is not optimal. Our view is definitely not unique. All economists would

welcome structural reforms as a complement to loose monetary policy. Unfortunately, such

reforms have no chance of passing Congress. President Obama has not even tried. Bernanke

has on several occasions appealed to Congress to do its share to speed up recovery, but

overall pressure on Congress has been weak. A major reason is likely the strong focus on

monetary policy and the Fed. Appropriate structural measures could take the form of retraining

programmes for the unemployed and improvements in the education system, including access

to higher education for children from low-income homes and investment in new infrastructure

(for instance, broadening access to high-speed internet).

1 The Fed has explicitly stated its ambition to press down longer-term bond yields, on residential mortgages in particular, while no corresponding assurances have been made for equity markets.

Investors focusing

more on Fed than on

the real economy

As aggressive policy

as possible, accord-

ing to Ben Bernanke

Bernanke in favour

of structural reforms


17

To widen our perspective, we compare the US situation with the Swedish economic crisis in

the early 1990s, which had a very different policy response. In Sweden, a dysfunctional la-

bour market led to high wage increases and inflation, which, combined with a fixed ex-

change rate, eroded global competitiveness. Export-dependent businesses closed down and

unemployment skyrocketed. Public finances, the banking system and the housing market

were hit hard. Eventually, the fixed exchange rate was abandoned and a series of structural

reforms were launched. Ultimately, that led to low and stable inflation, sustainable public

finances, financial stability and high productivity growth. Real bond yields were high during

most of both the economic decline and the recovery, but after the introduction of a floating

exchange rate, the SEK weakened sharply, boosting exports and curbing imports.

In the US, aggressive monetary policy and capital support to the banking system via the

TARP programme fixed the financial system and prevented a really deep contraction, but

the measures did not kick-start business investment and employment. Structural reforms

(i.e. fixing fundamental economic problems) seem necessary to create the conditions for a

strong recovery. The Swedish focus on structural reforms in the early 1990s likely deepened

the economic contraction and made it more protracted, but it did kick-start the recovery.

When will the unemployment rate hit 6.5 percent?

The unemployment rate, which peaked in late 2009 at 10 percent, declined faster than the Fed

expected and hit 7.0 percent in November of this year. If the decline were to continue at the

same pace, the unemployment rate would hit 6.5 percent, the Fed’s threshold for starting rate

hikes, in 12 months. In other words, a simple linear extrapolation of the unemployment rate

decline points to a first Fed hike in late 2014, which is exactly in line with our Fed forecast. Be

that as it may, the Fed has emphasised that an unemployment rate of 6.5 percent is not a trig-

ger for hiking rates. If appropriate, policy rates could stay unchanged at their present low levels

long after the unemployment rate has dropped below 6.5 percent.

The US crisis vs. Swe-

den’s in the 1990s

Structural reforms to

kick start recovery

Unemployment de-

clined faster than the

Fed expected


18

There is a good chance of the unemployment rate hitting the threshold rate of 6.5 percent

sooner than in 12 months; in other words, in the second half of 2014. The monthly increase

in non-farm payrolls needed to keep the unemployment rate unchanged (the break-even

pace) has declined in recent years. In 2009, the break-even pace was roughly 100,000, but

it has now declined to 50,000. A major reason is slower growth in the labour force due both

to demographic factors and to an increasing number of distressed workers leaving. We es-

timate that dropouts at present amount to 1-2 percent of the labour force.

Expect bond yields to rise but remain historically low

To prevent bond yields from rising sharply, the Fed will likely combine the tapering of its asset

purchases with a change in its forward guidance to maintain the prevailing accommodative pol-

icy. One possibility is to lower the unemployment threshold for starting to hike rates to 6 percent,

from the current 6.5 percent, which would expand the period of low policy rates. However, finan-

cial markets would likely still interpret tapering as the start of a tightening cycle. In May-June of

this year, when the Fed signalled that tapering was imminent, financial markets interpreted that

as a signal of more rapid rate hikes too and long bond yields rose significantly.

When the conditions that affect asset prices change, the price adjustments often take place

in two steps. First, prices adjust partly on the expectation of a change. Then, as the change

is realised, the rest of the price adjustment occurs. The stronger the expectations, the larger

the share of the price adjustment that takes place before the change is actually realised. At

present, financial markets are not pricing in any Fed hikes at all in the coming two years.

The two-year government bond yield (a rough estimate of average short interest rates over

the next two years) is 0.22 percent. If the credit market were to fully price in our Fed forecast

(0.50 percent within twelve months and 1.50 percent within twenty-four months), the two-

year government bond yield would rise to 0.6-0.8 percent. However, it is unlikely that finan-

cial markets would fully price in expectations. In the summer of this year, when financial

markets expected the Fed to taper in October, the two-year government bond yield peaked

at 0.5 percent. Moreover, the 10-year government bond yield topped out at 3 percent.

The longer the Fed waits to taper and hike interest rates, the higher the likelihood that ag-

gressive hikes will be part of an appropriate policy in the future. On the one hand, financial

markets seem to be almost addicted to the Fed put and low interest rates. On the other

hand, they seem to fear sharp selloffs of longer-term bonds and risky assets, which indi-

cates support for a timely start of the tightening cycle. Awareness is growing that interest

rates cannot remain low forever and that the exit from the current monetary regime will likely

become more turbulent the longer the Fed waits to start the long, difficult journey to more

normal and sustainable monetary conditions.

Petter Lundvik, +46 8 701 3397, [email protected]

Unemployment rate

to hit 6.5 percent in

H2 2014

Tapering will be seen

as the start of a

tightening cycle

Moderate rise in

yields if Fed tapers in

coming months…

Bumpy ride if Fed

waits


19

Key ratios GDP forecasts for Finland, percentage change y-o-y

Other key ratios, percentage change y-o-y unless otherwise stated

Interest rate and currency forecasts


2011 2012 2013F 2014F 2015F

Consumption 1.9 0.3 -0.6 0.5 1.0

Private consumption 2.6 0.2 -0.5 0.7 1.3

Public consumption 0.5 0.6 -0.8 0.2 0.2

Investments 5.7 -1.0 -2.7 1.7 5.0

Exports 2.8 -0.4 -0.3 4.0 6.5

Imports 6.2 -1.2 -2.1 2.2 5.4

GDP 2.7 -0.8 -1.2 1.5 2.2

2011 2012 2013F 2014F 2015F

Earnings 2.7 3.2 2.1 1.7 1.4

Consumer price index 3.4 2.8 1.5 1.6 2.2

Unemployment rate, % of labour force 7.8 7.7 8.1 8.1 7.8

Industrial production -1.4 -5.3 -3.0 3.5 5.0

Trade balance, bn EUR -1.3 -0.1 0.3 1.3 1.2

Current account, bn EUR -2.8 -3.2 -1.4 0.4 1.4

Current account, % of GDP -1.5 -1.7 -0.7 0.2 0.6

General govt financial balance, % of GDP -0.7 -1.8 -2.1 -1.7 -1.0

EM U debt, % of GDP 49.2 53.6 57.6 59.3 58.9

D ec 10 2013 6 m 12 m 24m 36m

EKP refi rate 0.25 0.25 0.25 0.25 0.25

Federal funds (USA) 0.13 0.13 0.50 1.50 2.50

Repo rate (Sweden) 1.00 0.75 1.00 1.75 2.00

10 year, Germany 1.82 1.80 2.00 2.10 2.20

10 year, US 2.82 3.00 3.30 3.40 3.50

10 year, Sweden 2.31 2.40 2.60 2.85 3.00

10 year, Finland 2.01 2.10 2.30 2.35 2.45

spread to Germany, bps 19 30 30 25 25

EURUSD 1.38 1.25 1.10 1.00 1.00

USDJPY 103.0 103.0 105.0 107.0 110.0

EURGBP 0.84 0.83 0.82 0.80 0.75

EURSEK 9.00 8.40 8.30 8.10 8.00


20

Global GDP forecasts, percentage changes, our previous forecast in grey


2012 2013F 2014F 2015F

USA 2.8 1.7 1.7 2.7 2.7 2.9 2.9

Euro zo ne -0.7 -0.5 -0.5 1.0 1.0 1.1 1.1

Japan 2.0 1.9 1.9 1.5 1.5 1.2 1.2

United Kingdo m 0.1 1.3 1.3 1.5 1.5 1.7 1.7

Sweden 1.3 1.0 0.9 3.2 2.9 2.4 2.5

D enmark -0.4 0.3 -0.1 0.9 0.7 0.8 0.8

F inland -0.8 -1.2 -0.2 1.5 2.0 2.2 2.2

N o rway (mainland) 3.5 1.8 1.8 1.5 2.0 2.0 2.0

C zech R epublic -1.8 -1.2 -0.8 1.7 1.7 2.3 2.3

H ungary -1.7 0.7 0.4 1.6 1.6 2.1 2.1

P o land 1.9 1.3 1.2 2.9 2.6 3.4 3.0

Slo vak R epublic 2.0 1.1 0.9 2.0 2.2 2.8 2.8

B razil 0.9 2.5 2.3 2.5 2.8 3.0 3.3

R ussia 3.4 1.6 2.2 2.5 2.8 2.9 3.1

India 5.1 4.7 4.5 5.0 4.7 5.5 5.5

C hina 7.8 7.6 7.5 7.3 7.3 7.0 7.0

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