Davos dilemma: How to help, not harm, world's fragile recovery

On the face of it, a combination of record low interest rates, ample liquidity and faster economic growth should sustain the world's recovery from financial crisis this year.

Confident that the outlook for the world's biggest economy is brightening, the Federal Reserve has paved the way for an end to its stimulus programme and, after a bout of market turmoil last year, investors seem prepared for the shift.

But the U.S. central bank's effort to return to pre-crisis policy settings still represents a huge leap in the dark as it exits from an unprecedented bout of money printing.

An ill-judged move could threaten economic revival worldwide, just one of the dilemmas facing policymakers from America, Europe and Asia as they gather this week for an annual meeting in Davos.

Protagonists will include U.S. Treasury Secretary Jack Lew, Japanese Prime Minister Shinzo Abe, European Commission President Jose Manuel Barroso and central bankers Mark Carney, Mario Draghi and Haruhiko Kuroda. A "senior leader" from China is also expected.

Broadly, the risks they face are slower-than-expected U.S. growth, euro zone deflation, an absence of structural reforms in Japan, and bad loans in China. There will doubtless be others.

"While the Fed is trying to normalize monetary conditions to avoid a credit bubble, China is trying to implement financial sector reforms to bring one to an end," said Michael Spencer, economist at Deutsche Bank. "Both potentially threaten the sustainability of growth."

The balance of risks for this year may be tilted towards the United States and the euro zone, even if the policy challenges facing Japan and China appear greater.

Investors have already priced in a lot of good news, with European shares hitting a 5-1/2 year high last week. The risk is that weaker-than-expected growth could knock markets and unsettle the global recovery.

"What could trigger a correction is that growth turns out to be weaker than markets have discounted," said Andrew Bosomworth, a senior portfolio manager at Pimco, the world's largest bond fund. "In the case of equities, markets have discounted some pretty rosy economic conditions."

THE GENIE AND THE OGRE

The challenge for policymakers in the United States and Europe is to manage policy expectations at a time when inflation is not performing as expected.

Some Fed officials worry tepid price rises mean the U.S. recovery is not as solid as it seems. With growth and job creation should come inflation.

Given that uncertainty, U.S. central bankers must convince hesitant consumers that even if the era of quantitative easing is drawing to a close, an interest rate rise remains a long way off.

"The Fed's next challenge is not over tapering, it's over rates and guidance," said Sassan Ghahramani, CEO of New York-based SGH Macro Advisors, which advises hedge funds.

If it fails to convince, market interest rates which often set the cost of borrowing could rise too quickly and choke off recovery in the United States and beyond. If that happens, investment will leach out of emerging markets as U.S. funds return home lured by higher returns.

"It's a corollary of quantitative easing and easy money going to emerging markets," said Ghahramani. "Now that there is less of that QE and easy money, where does it come out of? It comes first out of those markets."

If low inflation is a puzzle in the United States, prices could actually start falling in Europe.

IMF Managing Director Christine Lagarde, who speaks at Davos on Thursday, expressed concern last week.

"If inflation is the genie, then deflation is the ogre that must be fought decisively," she said.

European Central Bank President Mario Draghi - feted at Davos last year as the euro zone's saviour - draws a distinction between deflation as a protracted fall in prices, and necessary internal price adjustments in some countries allowing them to become more competitive.

"The risk is that the internal devaluations that need to be done in these countries morph into deflation," said Bosomworth.

Draghi is talking up the ECB's readiness to act but it shows little appetite to embark on a round of Fed-style quantitative easing to stimulate the economy.

In the meantime, the deflation threat stalks the bloc.

Euro zone inflation is running at 0.8 percent. That is well below the ECB's target of just under 2 percent but it stands at almost minus 2 percent in Greece.

In Italy, the bloc's third largest economy, the rate is just 0.7 percent and if Rome gets serious about tackling its towering debts - at 130 percent of GDP - inflation and growth could evaporate and make paying down that debt even harder.

"We can't just look at deflation risk in isolation," said Bosomworth. "It's linked at the hip to debt sustainability."

ABENOMICS: TIME TO DELIVER

In Japan, policymakers have had some success with their efforts to fight deflation after years of economic stagnation.

Their plan - dubbed "Abenomics" - is to combine fiscal spending, economic reforms and monetary stimulus to pull the world's third-biggest economy out of its long slump.

Premier Abe's efforts have paid dividends with Japanese growth outpacing its G7 counterparts in the first half of 2013.

However, some policymakers beyond Asia see the policy cocktail as a high-risk strategy about which they have doubts, particularly as progress on reforms aimed at boosting the economy's long-term growth potential has been slow.

A Reuters poll of economists conducted last week found a consensus that Japanese companies are unlikely to raise wages much this year and inflation will remain well below the official target of 2 percent.

With a few high-profile exceptions, businesses are cautious about passing on higher profits to their employees, which is seen as vital to Abe's hopes for sustained growth.

Abe has also yet to deliver on promised long-term reforms to counter the drag of Japan's ageing and falling population and to reduce the country's massive public debt.

Having said that, the poll predicted the economy will continue to recover this year as companies and consumers rush to beat a planned rise in sales tax.

And unlike much of the world, Japan will avoid any U.S. backwash from its policy shift, rather its exporters will benefit if the dollar strengthens as U.S. market rates rise.

"The Japanese rates market does not track the U.S. rates market at all, so they don't get hurt by rising U.S. rates but they benefit from the rising dollar, so they get a nice free ride from the U.S," said Ghahramani.

Perhaps of even greater importance than Japan's policy mix is China's ability to take excess credit out of its economy without causing a crash. The Chinese economy grew 7.7 percent in 2013 but slowed in the final three months.

There is little sign of a sharp tightening in monetary policy, but rising money market rates and bond yields in recent months indicate the People's Bank of China is committed to removing excessive debt from the economy.

"Rumours of an imminent financial crisis in China have been around for years," said Berenberg bank economist Robert Wood.

"But China can deal with these problems," he said. The government seems ready to accept lower rates of GDP growth as long as that growth is sustainable and does not cause politically dangerous mass unemployment."

Copyright: Thomson Reuters 2014