The market’s mood has worsened in spite of impressive growth
figures in the US and China.
Share prices have fallen after a strong January bounce. In the eurozone,
fears of contagion are growing and the idea of a break-up, though still
unlikely, is being taken seriously.
Greece’s problems have escalated into a major crisis, engulfing the eurozone
and threatening its stability. Greece’s credit rating has worsened; and without
outside help, it risks default. Other eurozone members are reluctantly being
forced to reassess the rule not to bailout members.
Allowing Greece to default may unleash speculative attacks on Portugal and
Spain and threaten to destroy the euro. Current proposals of vague support will
not reassure the markets and the euro is set to remain under pressure.
China’s annual growth accelerated to 10.7% in the fourth quarter of 2009, more
than expected. In 2009 as a whole, despite a huge global crisis, China’s economy
grew by 8.7%. But stronger Chinese growth coincided with higher inflation. The
Chinese acted to restrain bank lending and will probably raise interest rates
earlier than previously expected. The initial impact will be felt in the rest of
Asia and Australia. Policy tightening in China, without currency appreciation,
will heighten trade tensions with the US and Europe.
US GDP grew at an annualised rate of 5.7% in the final quarter of last year,
the fastest since 2003. But concerns remain. The turnaround in stocks can
sustain recovery only temporarily. Beyond the initial bounce, underlying US
growth prospects are uncertain. Banking sector weakness, pressures to reduce
deficits and debt levels and high unemployment will constrain US spending.
The January 2010 US job figures, which showed a 20,000 fall, were disappointing.
Since December 2007, 8.4 million US jobs have been lost, much more than
initially estimated. Exports are benefiting from a competitive dollar. But
progress is inadequate and strengthening exports is a key US policy aim. If
China and other surplus economies insist on persevering with an export-driven
growth model, US protectionism will intensify.
Honeymoon over as markets spurn Obama advances
The financial markets remain torn by conflicting fears of an immediate slump,
unsustainable debt burden and future inflation. Deflation is a short-term risk.
In 2009, the US will experience its first full-year fall in consumer prices for
more than 50 years. But the markets are also worried that massive injections of
stimulus and increased borrowing will unleash higher inflation.
US jobs fell by almost 600,000 in January, the biggest fall in 34 years and the
third month in a row of declines exceeding half a million. US job losses since
the beginning of the current recession now total 3.6 million and are set to
worsen in 2009. House prices are falling at their steepest pace on record. The
1% rise in US January retail sales was a surprising piece of good news.
Europe’s downturn is steeper than in the US. Eurozone GDP plunged 1.5% in the
fourth quarter of 2008, the same decline as in the UK, but more than the 1% fall
in the US. Germany, with its heavy exports dependence, has been particularly
badly hit by the global recession.
The European Central Bank persists with its obstinate stance and has kept its
key rate at 2%. While rate cuts are now almost certain, policy remains too
tight. In the UK, Bank rate was cut to 1% and further cuts to 0.5% are likely.
But sterling’s weakness exposes the UK to serious risks. In the US, the Federal
Reserve says it will keep its key rate at almost zero for a considerable time.
But policy must now focus on quantitative and credit easing. The Fed has led the
way with aggressive interest rate cuts and is more determined than Europe to
boost the money supply by purchasing government bonds.
But negative reaction to the Obama banking package is because of US
ideological reluctance to take measures that entail any bank nationalisation. A
more flexible US line is needed that absorbs the lessons of Japan. Without
sorting out the banks, there will be no recovery.
Fed easing unleashes big market changes
The Fed slashed its key interest rate by 125 basis points over a period of eight
days in January. This remarkable policy easing confirmed that immediate threats
to growth override inflation risks at present. We will not know for some time
whether the Fed was right, or whether it panicked and misjudged the situation.
But the Fed’s moves reflect deep conviction that forceful action is needed to
avoid recession. The contrast with Europe is striking.
Since the credit crisis started in August, the ECB has kept its key rate
unchanged at 4%, while the Fed has cut rates from 5.25% to 3%. Eurozone official
interest rates, after being persistently lower than those in the US for two
years, are now 100 basis points higher. The gap in rates will widen further
before it starts narrowing. The Fed is determined to continue easing and its key
rate could reach 2.5% before mid-2008.
The ECB remains concerned with inflation, but has acknowledged that slower
eurozone growth justifies modest easing. The markets expect a cut to 3.75% in
April. The UK has cut Bank rate in February from 5.50% to 5.25%. Most analysts
expect UK rate cuts to 4.75% by mid-2008, but the forward market signals bigger
The US dollar weakened sharply in 2007, driven by fears that US growth is set to
plummet and by lower US rates since August. But the dollar has risen in recent
weeks, even though interest rate relativities have moved sharply against the US.
The dollar remains vulnerable. But there has been a critical change.
The markets now believe that, though the US economy will weaken in the near
term, measures taken by the Fed and the Administration will ensure that the
downturn is brief. In 2009 and beyond, US growth prospects are certainly
stronger than those of the eurozone and Japan. It is particularly important for
the Chinese yuan to strengthen. But a dangerous dollar rout is unlikely in 2008
and this is good news for the global economy.
David Kern of Kern Consulting is chief economist at the British
Chambers of Commerce. He was formerly NatWest Group chief economist