Global economic growth was stronger than expected in the first half of 2010, but lost considerable momentum in recent months. There are now clear signs that activity is slowing, particularly outside the manufacturing sector. Fears of a double-dip recession have intensified. A new downturn can still be avoided, but it is now widely expected that growth will slow in the second half of 2010 and in 2011.
In reaction to a flood of disappointing figures, US growth prospects have worsened. The housing market is depressed, with weak home sales and falling housing starts. Many mortgage holders are defaulting. Large numbers of unsold houses will exert downward pressure on prices. Meanwhile, US employment fell by 131,000 in July, much worse than expected and the second decline in a row. Private sector jobs are rising at a feeble and inadequate pace; discouraged workers are leaving the workforce and the jobs outlook is poor.
US GDP slowed sharply in the second quarter of 2010, as weaker consumer spending and a rising trade deficit dampened the upturn. Revised figures show that in the US, recession was deeper and growth before the downturn lower than previously thought. Recent US data on consumer confidence and retail sales is poor.
The outlook for US inflation has been transformed. There are renewed concerns that the US may face a dose of deflation in the near term, even though fears still persist that huge injections of fiscal and monetary stimulus may worsen longer-term inflation risks. Signs that the Federal Reserve is taking seriously downside threats to the economy and may consider injecting a further dose of quantitative easing have become dominant influences in the markets, triggering sharp falls in the US dollar and bond yields. More cautious voices, suggesting that the pessimism about the US economy may be exaggerated, have been overwhelmed for the time being.
The abrupt shift of attention from eurozone troubles to those of the US is a timely reminder that the herd instinct can drive markets in the short term. The economic fundamentals in the eurozone remain dire. There are acute divergences between economic strengths in Germany and other core members in the north and persistent weaknesses in the southern periphery; unless these are tackled, the long-term survival of the euro is definitely not secure and new crises will erupt (see our cover story on page 24). Eurozone growth forecasts remain persistently weak. As our interest rates table shows, even after recent downward revisions, US growth is set to remain consistently stronger than in the eurozone. Germany, the strongest eurozone economy, will grow more slowly than the US.
At the height of the Greek debt crisis in early June, the euro plummeted to $1.19 per dollar, compared with $1.45 at the beginning of 2010. Some analysts were predicting a further euro decline to parity with the US dollar. But the downgrading in US growth prospects and expectations of further Fed interventions have recently pushed the euro to levels above $1.30. A stronger euro may be acceptable to Germany with its relatively strong economy, but the implications are negative and dangerous for weaker eurozone economies and for the bloc as a whole. Meanwhile, a weaker dollar will benefit the US, supporting exports without raising inflationary fears at a time when deflation has re-emerged as a short-term US concern.
In Asia, growth also appears to have weakened. Recent figures in Japan show an increase in the unemployment rate and a fall in industrial production, while deflation remains a serious problem. Even in China, there are signs that the very rapid pace of expansion may be about to slow later in the year. Although year-on-year Chinese GDP growth eased only slightly between the first and second quarter of 2010, very weak industrial output for June indicates that China’s slowdown may intensify later this year.
China’s decision in June 2010 to relax the yuan’s peg against the US dollar, in order to alleviate protectionist pressures in the US Congress, will have minor and short-term effects only. But the longer-term consequences could be far reaching. China will not allow a clean float of its currency. Changes in the value of the yuan will be slow, gradual, and controlled. But a more flexible yuan, which moves slowly towards greater convertibility, could evolve over time into a major reserve currency.
Early in 2010, there were widespread expectations that the major central banks would start raising official interest rates in the second quarter of the year. The eurozone crisis, resulting from fears of sovereign default, forced a reassessment: by June, the final months of 2010 emerged as the most likely time of the first interest rate increase.
More recently, signs of slowdown in the US and China and moves by many European countries towards policies of aggressive fiscal austerity have resulted in a further delay in the timetable for interest rate increases. We are now predicting that the major central banks will keep official interest rates at their current very low levels until the second quarter of 2011 at the earliest: the US Fed at 0-0.25 percent, the European Central Bank at 1 percent, the Bank of England at 0.5 percent and the Bank of Japan at 0.1 percent.