In the light of our experience this year, there are two important determinants for the U.S. First, of course, is the U.S. Federal Reserve (Fed). If it does not start on December 17-18 on this year's last meeting, when and how severely it will begin to reduce the amount of bond purchases will be the primary determinant and it looks that it will start in the next quarter after the taking office of the new chairman. After that the Fed raised that possibility in May, the net capital inflow to developing countries decreased dramatically and therefore, the exchange rates and the interest rates spreads jumped. The reduction of net capital inflows decrease the rate of credit flow after a while. Consumption and investment spending are adversely affected; the growth rates are declining. Because it will lead to similar movements in 2014, the Fed's decision is very important.
The second determinant is whether the well known fight which has the risk of locking the fiscal policy of the United States will continue in 2014. The first test is in the first months of 2014: let's see what the Republicans and the Democrats are going to do. If the public sector is led to a shut-down of its system, the Fed's decision (if it does not start within this period of time) in terms of timing and/or severity may be affected: it may be postponed a few months and the purchase amount may be reduced further. The challenge of building a baseline scenario for 2014 has emerged while discussing the United States. We still have in store the uncertainties related to Europe.
There have been several positive developments related to Europe this year. First, several small steps have been taken towards the establishment of a common banking authority. Second, with the exception of Italy, the unit labor cost of the troubled countries is dropping. It has not reached yet the Germany's level but there's an improvement which is considered as to be one of the biggest issues of the Euro zone. But nonetheless, Europe is growing slowly and the inflation is very low.
In that case, whether the European Central Bank (ECB) will or not loosen further the monetary policy is under discussion. What kind of path will the ECB follow depends on two factors: the first element is as to how the inflation will take shape in the coming months which leads to concerns such as "Is the scourge of deflation coming?" due to the fact that the inflation dropped below 1% during the previous two months. Secondly, of course, is the growth rate. If there isn't any development in this area and the inflation continues to remain below 1%, ECB may take steps for additional measures. It has the option between three tools that can be used together and which are not mutually exclusive: to reset to zero the monetary policy's interest rate which has been reduced to 0.25% during the course of this month. The banks will not accredit and give negative interest rate to the deposits held with ECB. Issuing more money by purchasing more bonds. The first one is the more likely. The second one is somehow doubtful. And the third one is a policy that could irritate Germany.
Consequently, I want to give an "early" basic scenario. "Early" because a significant part of the scenario depends on what the Fed is going to do. The Fed is meeting on December 17-18. In this meeting, there is a possibility that the "feared" decision is going to be reached. Even if it is not reached, its statements may change the expectations regarding the timing and the severity of the decision. If this is the case, then I will update my current scenario under the heading of "new base scenario". For the time being, my assumptions about the external conditions are as follows:
The Fed will gradually decrease the third quantitative easing during the course of the year and will reset it to zero. Even if it does not start it at the end of this year, it will begin in March. On the other hand, in accordance with what was previously announced, the monetary policy's interest rate will remain unchanged in 2014.
Uncertainties related to the fiscal policy in the U.S. will not be on the rise as compared to 2013. In different terms, the Republicans and the Democrats will continue their disputes in front of a scared world. But they will agree before the time is up. Meanwhile, the first test of the correctness of this assumption will take place in the first months of 2014.
Europe will not have a deflation and will recover, albeit very slowly: Europe is not expected to grow in 2013. By contrast, the IMF is predicting that it will grow by 1.3% in 2014. And the forecast for the Euro zone is at the level of 1%. On the other hand, the economic programs in force in the troubled countries will be continued. To put it differently, the questions of "Does the Euro zone crash?" will not come up. In this case, ECB will not undertake the monetary easing by purchasing bonds. There is a possibility to set to zero the monetary policy rate of 0.25%.
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