Persistent hopes that US growth will strengthen this year have pushed equity prices to new highs. In February, the Dow Jones Index rose above the 12,000 mark for the first time since mid-2008. Other stock markets have also recorded gains. In forecasts for 2011, GDP growth is being revised upwards, mostly for the US, but also for the global economy.
But two worrying issues are now unsettling the positive mood. One, fears over inflation have worsened, which in turn is leading to concerns that higher food and energy prices, coupled with pressures on some central banks to hike interest rates, will cause the world recovery to stall.
And two, the eruption of anti-government demonstrations throughout the Middle East, notably in Egypt, has reinforced these concerns by highlighting the global economy’s vulnerability to geopolitical instability.
Moves towards greater democracy in the Middle East are generally welcomed elsewhere. But there is acute awareness that turmoil in a region that is crucial to the world’s energy supplies could be highly damaging. In a worst-case scenario, the crisis could produce regimes that are volatile and potentially hostile to the West, leading, in extreme circumstances, to the interruption of the smooth flow of oil through the Suez Canal. Many still remember that Middle Eastern crises contributed to surges in oil prices and to nasty world recessions in the 1970s.
Events will remain fluid and uncertain for some time. The markets are still predicting a benign outcome, and optimism continues to be fuelled by expectations that the forceful US policy stimulus recently passed, which combines $600bn (£372bn) in quantitative easing and some $850bn in fiscal measures, will prove a powerful driving force this year, for both the US and the wider global economy. Signs that the eurozone sovereign debt crisis is receding have reinforced these hopes.
In the US, GDP growth accelerated to an annualised rate of 3.2 percent in the fourth quarter of 2010, an improvement on the 2.6 percent seen in the third quarter but still a slower pace than the markets expected. Much stronger consumer spending and rising exports were the main US growth drivers in the fourth quarter, and strong manufacturing output and retail sales are positive features. But the weak housing market in the US, with persistent falls in prices and in activity, will force consumers to reduce debt and will dampen future spending.
The US labour market is not creating enough jobs. Employment rose by only 36,000 workers in January, far fewer than expected and the smallest gain in four months. The US jobless rate, which is measured by a separate survey, conveys a more cheerful message: it fell to nine percent in January, its lowest level since April 2009 – but this was partly due to a decline in the size of the US workforce as many people are still discouraged from seeking work.
The markets have chosen to focus on the lower US jobless rate, and reacting by pushing up share prices further. But the Federal Reserve remains concerned over inadequate job creation and is determined to persevere with expansionary policies. In spite of mixed economic figures, there are realistic hopes that US growth will strengthen in the short term. But the US economy is still facing serious obstacles.
The stimulus that is driving US growth in 2011 will have to be withdrawn gradually, given the need to reduce the unsustainable fiscal deficit. As a result, our forecasts point to slower growth in 2012 than in 2011, both in the US and globally. But the scale of the likely slowdown – whether we have a “soft” or a “hard” landing – will depend to a very large extent on how the major central banks react to recent surges in inflation.
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Even before the recent upheavals in the Middle East, the markets signalled their concerns over the sharp increases in energy and food prices. In addition to causing direct damage by squeezing disposable incomes in the importing countries, higher commodity prices may force central banks to raise interest rates if higher inflation becomes embedded in expectations and triggers harmful wage-price spirals. While everyone agrees that an upturn in inflation is unwelcome, there is acute disagreement on how to respond, and the key global players are adopting different policies.
In fast-growing Asian economies such as India and China, higher inflation is driven by excess demand. The main policy challenge is to continue tightening policy without also causing undue damage to growth. Both China and India have already raised their interest rates as well as their bank reserve requirements, and this process will almost certainly continue. At the other extreme, Japan is still facing deflation, and it is likely to keep its official interest rates at or near zero for some time. But the position of the US and Europe is less clear-cut.
In the US, the Fed believes that core inflation is still unduly low and is determined to persevere with expansionary policies aimed at supporting jobs and growth. In spite of longer-term risks, the Fed will keep its key policy rate at 0-0.25 percent for some time, and will implement its $600bn quantitative easing plan. But in Europe, in reaction to above-target inflation figures, both the UK and the eurozone are facing demands for the adoption of a tougher line than previously envisaged.
However, premature rate increases could be damaging and are still being resisted. But pressures are increasing, and European rates will probably start increasing before mid-2011.
David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist