The new year started on a positive note. After performing strongly in December 2010, the financial markets continue to signal optimism about growth prospects in 2011. Share prices rose to levels not seen since before the collapse of Lehman Brothers in 2008.
The good news is that a new recession is unlikely in 2011. Growth forecasts have been raised significantly for the US. Fears that new crises might unleash a fatal attack against the eurozone have also diminished. But the surge in optimism is almost certainly exaggerated. There is a dangerous tendency to magnify the importance of favourable short-term factors, while deep-seated dangers are being ignored. New setbacks cannot be ruled out. Recovery, though likely to continue this year, will be patchy.
Hopes of stronger growth were fuelled by aggressive US policy stimulus introduced in recent months. After the Federal Reserve Bank of New York announced an additional $600bn in quantitative easing in November, president Barack Obama and the Republican leaders in Congress agreed in December an expansionary fiscal package totalling some $850bn. The new US programme extends for two years, expiring tax breaks from the Bush era, and introduces other recovery-supporting measures, including an extension of benefits for the unemployed and a cut in payroll tax. These actions, particularly the fiscal stimulus, will almost certainly produce stronger growth in the short term. But one cannot ignore concerns that the huge US budget deficit may become unsustainable.
The US measures can be defended as a temporary emergency. But the absence of a realistic medium-term plan to reduce the deficit is potentially irresponsible and raises concerns over the eventual erosion of US creditworthiness. Even before the new stimulus was agreed, credit rating agency Moody’s warned that the US triple-A rating would be threatened without effective measures to reduce the deficit. In the near term, the Fed is still concerned with averting deflation. But the combined effect of ballooning deficits and additional money creation through quantitative easing is bound to worsen fears of higher inflation. These fears are accentuated by the increased political paralysis in Washington after the recent midterm Congressional elections. The stalemate between a resurgent Republican Party and a weakened Barack Obama will encourage populism and make it difficult to address long-term problems.
Given this uneasy background, it is reassuring that the US real economy is continuing to recover. But the US indicators are mixed and the economy’s performance is mediocre, rather than sparkling. On the positive side, exports, manufacturing output and retail sales are all rising, and the US trade gap is shrinking. However, the housing market remains weak and the improvement in US employment is still inadequate.
For the politicians as well as the Fed, the key policy priority for 2011 is to avoid risks of a jobless recovery. Until there is a much clearer improvement in the US jobs market, the Fed will keep its key policy rate at the current extremely low level of zero to 0.25 percent, and will implement its quantitative plan of purchasing $75bn in long-dated Treasury bonds each month until the end of June 2011.
In contrast to the aggressive policies adopted by the US, both fiscal and monetary, the eurozone’s stance remains less expansionary and will become even more restrictive in 2011. Many eurozone economies will tighten fiscal policy quite forcefully in 2011. Unlike the Fed, the European Central Bank will not increase quantitative easing and will start raising official rates relatively early – probably in the second quarter of 2011.
Traditional German concerns with fiscal prudence and low inflation tend to produce policies that are more restrictive than those resulting from the US, overriding desire to deliver growth and create jobs. But imposing the German approach on the eurozone as a whole could prove very dangerous. Eurozone growth, though lower than in the US, is still tolerable. But the overall figure masks sharp divergences between German strength and acute weaknesses in the periphery arising from the debt crisis. These contradictions and tensions can be dealt with in 2011, but they will intensify long-term threats to the euro’s survival as a single currency.
The UK also faces critical challenges. VAT increased to 20 percent recently, and the coalition’s deficit-cutting plan will be implemented more aggressively in the first half of 2011. This will be a risky period.
Inflation was above three percent since the beginning of 2010, well above the target, and increases to almost four percent are expected shortly due to higher food and energy prices. UK rates will have to rise before the end of 2011, but the Bank of England must wait until the economy absorbs the initial impact of the austerity plan. Premature increases of the interest rate risk derailing the recovery.
Inflationary pressures are particularly acute in the emerging markets, most significantly in China. After consumer price inflation soared to a 28-month high of 5.1 percent, the Chinese authorities announced a surprising interest rate increase on Christmas Day. But China’s official rates are still less than 0.5 percent in real terms, and it is clear that taming inflation will require more tightening. But higher rates will harm growth and, by attracting capital inflows, will put upward pressure on the currency and damage vital exports. These dilemmas are very difficult to reconcile. But if China and other emerging economies avoid making difficult choices, risks of capital controls and global protectionism will worsen.