The markets have recently witnessed exceptional fluctuations in oil and other commodity prices. Equities and currencies have also been volatile. Earlier optimism is repeatedly being questioned by recurring bouts of anxiety. Sharp swings in various asset prices reflect growing doubts as to whether earlier underlying expectations of continued growth and manageable inflation are still sustainable. It seems that it will be very difficult to indefinitely shrug off worsening risks of sovereign debt, inflation and interest rates.
Global growth forecasts have moved higher, but this is primarily due to the acceleration in the BRICs (Brazil, Russia, India and China), and to their rising share of global GDP. In the US, growth forecasts are down, and there are concerns that the outlook for other mature economies may be worsening. Global growth in 2011 is still forecast to be lower than in 2010 and 2012 is expected to be slightly weaker than 2010.
China’s GDP grew 9.7 percent year on year in the first quarter of 2011, which represents a slight fall from 9.8 percent in the previous quarter, but it is still much higher than expected. While such spectacular growth is an unattainable dream for many in the West, Chinese authorities regard the pace of expansion as unsustainable and dangerous, claiming it adds to inflation and heightening threats of bubbles in property and other assets. As Chinese annual inflation has risen to between five and 5.5 percent, monetary policy has also been tightened, through repeated increases in interest rates and banks’ reserve requirements.
Further restrictive measures are very likely. The government wishes China’s growth to slow to seven percent a year over the next five years. But this will be difficult to achieve, as excessive investment and strong exports continue to drive the economy. At the moment, the markets expect a “soft landing” for China, with growth and inflation slowing gradually but still avoiding a nasty crash. However, if inflation accelerates or the economy nosedives, there would be unpleasant consequences, not only for China but also for the global economy.
The US situation remains mixed. In April, 244,000 jobs were added, which was more than forecast. However, the jobless rate rose for the first time since November, edging up to nine percent in April as more people joined the workforce and looked for work. The improvement in the labour market, though real, is still inadequate, and other US indicators are also still disappointing. GDP growth slowed more than expected in the first quarter of 2011 to an annual rate of only 1.8 percent, which represented a sharp fall from 3.1 percent in the previous quarter. The US housing market also remains weak. With many homes still in foreclosure, there is an overhang of housing supply that will delay recovery and depress consumer confidence for some time.
US rating cut
However, US inflation has been rising steadily in recent months, with consumer prices 2.7 percent higher in March than a year ago. Energy and food items account for the bulk of the increase in prices, but core inflation is also rising, and this makes the Federal Reserve’s job more difficult. Though the Fed expects inflation to fall to levels below two percent next year, it cannot ignore the fact that the 17 percent trade weighted fall in the US dollar since August 2010 is a major factor contributing to inflation.
Given its commitment to supporting jobs and growth, the Fed will keep its key policy rate at between zero and 0.25 percent until the final months of 2011, while also completing its $600bn programme of asset purchases at the end of June. However, the Fed is going to stop buying assets after June, which will effectively tighten monetary conditions, initially only in the US but eventually at a global level.
The end of the second round of quantitative easing is likely to result in higher yields on longer-term bonds, and could also depress equity and commodity prices. There are already signs that risk appetite is diminishing across many markets. These restraining forces will probably intensify once the Fed starts raising short-term policy rates towards the end of the year and in 2012. The US will also be forced to start to start tightening fiscal policy.
Standard & Poor’s unprecedented decision to cut its outlook on US sovereign debt from “stable” to “negative” is a warning that cannot be ignored. Given this background, it is difficult to avoid the conclusion that US growth will remain – at best – mediocre in the next few years. The fast-growing BRIC economies will also have to slow down as they will need to restrain inflation.
Europe will reinforce dampening global forces. In the UK, the economy was flat in the last six months, with disappointing growth in the first quarter of 2011 which only offset the previous quarter’s fall. This will persuade the Monetary Policy Committee to keep the bank rate at 0.5 percent in the short term, but the tough fiscal austerity plan will continue to squeeze demand.
In the eurozone, the contrast between Germany’s strong performance and the acute weaknesses of the heavily indebted periphery has deepened after the European Central Bank’s (ECB) decision to raise its key policy rate from one to 1.25 percent. With inflation at 2.8 percent, the ECB rate is expected to soon be raised further to 1.5 percent, even though this will worsen pressures on the periphery. Portugal is the third eurozone member, after Greece and Ireland, to accept a bailout. The euro’s survival is not under immediate threat, but a speculative attack on Spain could prove very dangerous.
David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist