Buoyant markets betray real threat of second downturn

US jobs and Japanese fiscal strength should not occlude the risk of more shocks

15 Apr 2011

By David Kern

David Kern is chief economist at the British Chambers of Commerce

With their remarkable ability to magnify the importance of good news and shrug off dangerous developments and clear warning signs, the global financial markets are currently optimistic. The belief that the global growth momentum that built up in 2010 can continue uninterrupted in 2011 is turning out to be difficult to dislodge. However, while the positive mood may prove justified, it seems, on balance, more likely that the markets are displaying wishful thinking and dangerous complacency.

After starting 2011 on a positive note, with share prices rising to multi-year highs in January and early February, stock markets retreated between mid-February and mid-March. In reaction to a number of major shocks (Middle Eastern political turmoil, surging oil prices, natural disaster leading to nuclear crisis in Japan and worsening eurozone debt problems), equity prices fell by some six to eight percent over a few weeks – raising fears that the bull market that started two years ago was over. But the setback was short-lived. Once it became apparent that the situation may not be as bad as it had seemed, the markets recovered quickly, even though the events that triggered the setback have not been resolved at the time of writing. Major threats to the global economy will probably persist for the next year.

Stronger-than-expected job figures in the US and a modest upward revision in fourth quarter GDP growth to 3.1 percent annualised both added to the mood of optimism. Jobs in the US rose by 216,000 in March after a 194,000 increase in February, while the jobless rate fell unexpectedly to a two-year low of 8.8 percent. The better-than-expected figures, driven by private sector jobs, helped to ease fears of a jobless recovery. However, the improvement in the US labour market is still inadequate and does not guarantee a solid recovery. Any sustained US economic upturn will face serious obstacles; notably, acute weaknesses in the housing market. Sales of new US homes plunged in February to their lowest rate on record, while the median price for a new house dropped to the lowest level since the end of 2003, as a large overhang of foreclosed homes continues to depress prices. Credit conditions remain tight, rising energy and food prices are adding to the squeeze on household incomes, and it is not surprising that key measures of US consumer confidence fell to their lowest level since November of 2009.

In spite of the fragility of the recovery, most measures of US inflation are now edging up, and some of the more hawkish Federal Reserve officials are raising the possibility of tightening policy. But these are very early signals, and US policy will remain very expansionary in the near future. The Fed will keep its key policy rate at 0-0.25 percent until Q3 2011 at the earliest and it will maintain its $600bn quantitative easing plan until June. However, it is now less likely that the Fed will wish to launch additional quantitative easing measures after June.

There has clearly been a significant change in tone. Once recovery is under way, restraining inflation will be given increasing weight by the Fed, even if this means that there must be some moderation in the pace of growth. US interest rates will clearly rise in 2012, and the markets will then have to adjust to a new reality.

International intervention

Japan, which is still suffering from deflation, will adopt even more extreme expansionary policies to support economic recovery after the natural disaster and nuclear crisis. The Bank of Japan is likely to buy assets, boost bank liquidity on a bigger scale, and even monetise outright government debt. The Japanese currency surged to a record high after the earthquake and tsunami, as traders expected huge demand for yen to bring funds home for reconstruction. However, since a strong yen will harm Japanese exports at a critical time, the G7 undertook co-ordinated international intervention for the first time in a decade. The yen then decreased again, but Japan still faces a difficult year. Its 2011 GDP growth forecast has been cut sharply, and the global impact of the Japanese disaster is uncertain. Even if the nuclear crisis can be resolved quickly, global supply chains have been disrupted in key industries such as cars and IT due to Japan’s position as a major manufacturing power, and that risk remains.

In the eurozone, consumer price inflation rose to 2.6 percent, well above the European Central Bank’s (ECB) target of “just under two percent”. An early increase in official interest rates now seems imminent. Indeed, given the ECB’s concern to maintain a tough anti-inflationary stance, it is very likely that the increase will be faster than previously envisaged, and eurozone rates may reach two percent in the first quarter of 2012. Portugal is now in line for a bailout and higher rates will intensify pressures on periphery economies such as Greece and Ireland. The eurozone debt problem will not be resolved by the recent agreement to strengthen the inter-governmental support facilities. The risk of more bailouts and even defaults will worsen, with potential negative effects on eurozone growth.

In the UK, inflation accelerated to 4.4 percent, and the Monetary Policy Committee is under pressure to raise rates. But the economy’s fragility may lead to a slight delay as a tough austerity plan is being implemented. The markets now expect the first UK increase to happen in July, rather than May.

Global growth still has momentum. But with oil prices at $115 a barrel, fighting in Libya continuing, Japan’s prospects uncertain and rising inflation intensifying pressures for higher interest rates, risks of a global setback have worsened.


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