Comment: Double-dip fears cast shadow over spectacular gains

In the months since March, stockmarkets have recorded remarkable increases by any historical standard. But these gains do not necessarily foreshadow strong growth in real economic activity. The markets remain deeply divided and uncertain. There are clear risks of setbacks ­ both in the real economy and in the financial markets.

But there are signs that the crisis is ending. Housing markets are improving. Banking sectors are no longer facing imminent threats of collapse. Activity is stabilising. Massive fiscal and monetary stimulus injected in the past year has averted a precipitous collapse. But recovery is not assured. There are serious dangers of a double dip.

Unemployment
As unemployment climbs to new highs, heavily indebted US and European consumers cannot drive global recovery, but China and other emerging economies can help. We have seen marked moves in this direction: the G20, not the G7, is now the main global economic forum. But radical changes will not occur immediately.

China still refuses to revalue its currency significantly and will only permit a slow restructuring of its economy towards consumer spending. Europe, Japan and above all the US remain critical in the near-term and the risk of relapse among them is high. Large trade deficits in the US and large surpluses in Germany and Japan are major imbalances that have contributed to the crisis.

Currency
Sharp falls in the US dollar and sterling are part of the correction, but could trigger new upheavals. If tensions between the main global players remain unresolved, we risk unleashing a new crisis. In the face of huge budget deficits and unprecedented money creation, governments and central banks are uncomfortable. But the urge to adopt early exit strategies is dangerous. If we tighten policy too early, we will cause a new recession.

Cutting public spending and raising taxes to bring public finances under control will lower economic growth and reduce living standards. And longer-term risks of inflation are very real.

NOVEMBER 2008
Recession forces rate cuts, but inflation will return
Fears of financial collapse and concerns over deepening recession have forced governments and central banks to concentrate on alleviating threats to jobs and output, at the risk of higher future inflation.

Rates
As well as undertaking colossal banking sector bailouts, policymakers executed major U-turns in their monetary policies. Central banks have been forced to abandon the careful balancing of risks which usually guides their actions. The most dramatic step so far was a co-ordinated 50 basis point cut in official interest rates involving six major central banks including the Federal Reserve, the European Central Bank and the Bank of England. Significantly, and unusually, China cut its official rate at the same time.

Though it has not formally been part of the coordinated action, the involvement of the Chinese underlines the seriousness of the global risks.

With recessionary pressures worsening, we expect additional interest rate cuts, as well as more injections of public funds into various banking systems. The Fed, having cut its key rate to 1.50%, is likely to move to at least 1.25% in the next couple of months. The ECB defiantly and unwisely raised rates in July to 4.25%.

Prices
Inflation is still high, well above official targets in most western economies. The recent inflationary upsurge, driven by food and energy, is at its peak and inflation will slow sharply in 2009. But government deficits will inevitably balloon due to massive bank bailouts and the impact of deepening recessions on public finances. The resulting large monetary expansion must eventually reignite inflationary pressures.

To alleviate the recession we must accept these consequences. But inflation is not dead; it will resurface with a vengeance in the future and we will have to fight it again in less comfortable circumstances.

NOVEMBER 2007
Deceptive calm masks forex market threat
The markets are less tense, but display unusual contradictions. Share prices have risen to new peaks. In normal circumstances this would signal optimism, but stockmarkets display unrealistic hopes that the real economy would be sufficiently weak to force the central banks into aggressive interest cuts ­ though not so dreadful as to throttle company profits. The recent 50 basis point cut in the Fed funds rate to 4.75% and expectations of further reductions underpin the better mood.

Unemployment
Revised figures show August US jobs figures were better than initially feared. The US consumer is particularly vulnerable as the housing market deteriorates and tight credit conditions make it difficult for households to borrow. With US companies relatively robust and net exports improving, recession is unlikely. But consumer weakness is dragging the US economy into a second year of below-trend growth. Unemployment is set to rise and the Fed will have to ease in spite of inflation risks.

Rates
The European Central Bank and the Bank of England left rates unchanged in October, but both are moving to an easier stance. Interest rate increases are now off the agenda, but with 2008 growth forecasts revised down, I expect moderate interest rate cuts between now and the end of March: from 4% to 3.50% in the eurozone and from 5.75% to 5.25% in the UK. In the UK, the fear is that the crisis would harm the financial sector. Political opposition to euro strength, threats of protectionism, and speculation could unleash disruptive and damaging movements in the US dollar.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist.

Click here to read David’s May 2008 feature setting out the three worst-case scenarios for the global economy ­ and see if his predictions were right.