MacroScope

First quarter UK GDP figures will show whether Britain has succumbed to an unprecedented “triple dip” recession. Economically, the difference between 0.2 percent growth or contraction doesn’t amount to much, and the first GDP reading is nearly always revised at a later date. But politically it’s huge.

Finance minister George Osborne has already suffered the ignominy of downgrades by two ratings agencies – something he once vowed would not happen on his watch. And even more uncomfortably, he is looking increasingly isolated as the flag bearer for austerity. The IMF is urging a change of tack (and will deliver its annual report on the UK soon) and even euro zone policymakers are starting to talk that talk. It was very much the consensus at last week’s G20 meeting.

The government can argue that it hasn’t actually cut that hard – successive deficit targets have been missed – and that it does have pro-growth measures such as for the housing market and bank lending. But the inescapable political fact is that Osborne and his boss, David Cameron, have spent three years arguing that they would cut their way back to growth and that to borrow your way out of a debt crisis is madness. In fact, it’s arguably perfectly economically sane, given that if you get growth going, tax revenues rise and will eat away at the national debt pile.

Either way, elections are now only two years away and the government will have to galvanise an economy that has essentially flatlined for much of its tenure within the next year or so to reap any dividend with the voters.

It’s unclear quite where the austerity debate is in the euro zone. European Commission president Barroso says it has reached its limits, but the change of tack will probably extend no further than the granting of Spain, France and others another year (two at the outside) to meet their deficit targets. That decision is expected next month. The word is that others are unhappy with the bluntness of Barroso’s intervention.

There’s been a lot of noise surrounding the rhetorical shift away from austerity in the euro zone in recent days, the notable exception being Germany. It is now widely acknowledged that monetary policy alone cannot turn economies around. But of course it has a vital part to play.

That puts the focus on the European Central Bank and growing expectations that it will cut interest rates to a new record low next month. Yesterday’s poor German PMI could have been the tipping point. On three of the four times the survey reading has fallen below 50 since the collapse of Lehman Brothers a rate cut followed the month after. Germany’s PMI duly slipped into contractionary territory yesterday.

In all this, we shouldn’t lose sight of the fact that a quarter-point rate cut may move markets but will have only a small impact on the euro zone economy. It’s also true that the ECB has shown no signs of wanting debt-cutting drives to be mothballed. Its reaction to any shift in that direction remains to be seen.

A sudden turn for the worse across German companies should clinch an interest rate cut from the European Central Bank next week, or in June at the latest.

That’s because the latest PMI surveys, which have a decent correlation with economic growth, suggest the German economy  shifted back into reverse this month, against the expectations of economists.

And the one thing the ECB’s Governing Council never allows to pass is any sign that Germany, Europe’s No.1 economy, is floundering.

With debate about the balance between growth and austerity well and truly breaking out into the open, flash euro zone PMIs – which have a strong correlation to future GDP — are likely to show why a bit of fiscal stimulus is sorely needed. Talk of a European Central Bank rate cut is growing, euro zone policymakers at the G20 last week began to ponder loosening up on debt-cutting in an attempt to foster some growth and European Commission President Jose Manuel Barroso added his voice to the debate yesterday, saying the austerity drive had reached its “natural limit”.

Crucially, we haven’t heard similar from Germany but something is afoot, starting with the certainty that the likes of Spain and France will get more time to meet their deficit targets when the Commission makes a ruling next month. Portugal has already been given more leeway and today its finance minister will spell out new spending cuts which are required after the constitutional court threw out Plan A.

It’s a coincidence, but an interesting one, that this debate – frequently voiced in private over many months – has gone public just as THE academic study from 2010 which asserted that as soon as debt exceeds 90 percent of GDP growth is crushed, has been called into question.

All the talk of currency wars is mostly just that – talk. This week’s meeting of the Group of 20 nations at the International Monetary Fund was living proof. Despite speculation that emerging nations would redouble their criticism of extraordinarily low rates in advanced economies, the G20 ended up largely supporting the Bank of Japan’s new and bold stimulus efforts aimed at combating years of deflation.

Mr. currency wars himself, Brazilian Finance Minister Guido Mantega, told reporters Japan’s monetary drive was understandable given its struggle with falling prices and stagnant wages, even if he called for close monitoring of its potential spillover effects.

Outgoing Bank of Canada Governor Mark Carney said Japan’s action is consistent with the G20 communiqué that called for countries to refrain from competitive devaluation. Carney, the head of the G20′s Financial Stability Board, takes over the Bank of England in July. His comments echo recent remarks from Fed Vice Chair Janet Yellen.

The big euro zone development over the weekend was the re-election of ageing Italian President Giorgio Napolitano for a second term. The presumption is that to put himself through this again he must have got pretty serious expressions of intent from the warring political parties that they will strive for some form of grand coalition. That may have been made easier by the resignation of centre-left leader Bersani who was in danger of splitting his own caucus.

If that comes to pass it should push back the timing of fresh elections until next year at least, a welcome turn for markets which feared a new poll could result in an even more fractured outcome and put more power in the hands of the anti-establishment Five Star movement. All that means we should see a significant rally in Italian assets today. That should also benefit other peripheral euro zone bonds. Safe haven German Bund futures have already dipped at the open, Italian bond futures have leapt almost a full point and European stock futures are pointing upwards.

87-year-old Napolitano will address parliament later and could either rush through consultations with the parties or skip that step altogether since he’s already heard from them ad nauseam.

Discussions about central banking are often belabored by analogies to moving vehicles, which make some sense given that interest rate policy can act both as accelerator and brake on economic activity. Perhaps tired of being in the driver’s seat, Minnesota Fed President Narayana Kocherlakota decide to switch gears and talk about clothing instead.

In an attempt to illustrate that interest rates are low because of economic conditions, not the whim of policymakers, Kocherlakota compares monetary policy to a protective jacket that needs to be worn when the weather gets rough but can slowly be removed as the summer approaches.

Why have real interest rates fallen so much? At one level, the answer is obvious: monetary policy. The FOMC has announced its intention to keep the fed funds rate near zero at least until the unemployment rate falls below 6.5 percent. At the same time, the FOMC has bought over $3 trillion of longer-term assets issued or backed by the government. With inflationary expectations well anchored, these actions are designed to push downward on real interest rates and have been successful in doing so.

For Bank of Israel governor Stanley Fischer, this week’s high-powered macroeconomics conference at the International Monetary Fund was a homecoming of sorts. After all, he was the IMF’s first deputy managing director from 1994 to 2001. The familiar nature of his surroundings may have helped inspire Fischer to use a household analogy to describe the vaunted but often ethereal principle of central bank independence.

Fischer, a vice chairman at Citigroup between 2002 and 2005, sought to answer a question posed by conference organizers: If central banks are in charge of monetary policy, financial supervision and macroprudential policy, should we rethink central bank independence?  His take: “The answer is yes.”

In particular, the veteran policymaker, who advised Fed Chairman Ben Bernanke on his PhD thesis at MIT, argued various degrees of independence should be afforded to different functions within a central bank.

Are European bond investors looking for love in all the wrong places?

The premium bankers demand to hold various types of euro zone debt over that of Germany has recently come down. In normal circumstances, this might suggest markets are no longer discriminating between the risks associated with different member countries’ bonds. But analysts say the recent convergence is based on a precarious belief of ECB action rather than any real improvement in economic fundamentals.

Spain and Italy still offer a comfortable premium over Germany. But a narrowing in yield spreads that is being driven by a fall in the funding costs of Spain and Italy, rather than by a rise in German yields, gives reason for pause.

According to Lyn Graham-Taylor, fixed income strategist at Rabobank:

The fact there is almost no movement from Germany and a huge movement in peripherals is indicative to us of this convergence for the wrong reason.

“Reality is sticky.” That was the core of Adam Posen’s message to German policymakers on their home turf, at a recent conference in Berlin.

What did the former UK Monetary Policy Committee member mean? Quite simply, that the types of structural economic changes that Germany has been pushing on the euro zone are not only destructive but also bound to fail, at least if history is any guide.

Posen, who now heads the Peterson Institute for International Economics in Washington, argued Germany’s imposition of austerity on Europe’s battered periphery is the product of an instinctive but misguided fear of an inflation “ghost” that has haunted the country since the hyperinflationary spurt of the Weimar Republic in the 1920s and 1930s. However, Posen offers a convincing account of modern economic history that shows inflation episodes are rather rare events associated with major political and institutional meltdown — and not always around the corner.