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Cautious start to New Year as risks are still lurking

REAL economic growth was mediocre in 2013. Although there were signs of improvement in the final months of the year, GDP in most countries is still well below its pre-crisis trend. The financial markets remain more buoyant than the real economy. Share prices have recorded gains during 2013, partly reflecting the fact that threats that might have triggered major crises have not materialised. The markets’ optimism during last the 12 months have so far proved justified, but the new year has started on a cautious note. While there are realistic hopes that global economic growth will strengthen this year, many risks are still lurking. 2014 may prove a bumpier year than many anticipate, and making money will be more difficult in 2014 than in 2013.

The US Federal Reserve started to implement its long-awaited tapering at its December 2013 meeting, the last under Ben Bernanke’s chairmanship, without causing major disruptions in the US bond market. The Fed announced it is reducing its asset purchases from $85bn (£51.8bn) to $75bn per month, and indicated it was likely to continue scaling back its purchases by $10bn at each future meeting. The Fed also stressed it wished to “proceed cautiously”, and restated its guidance that official interest rates are likely to stay very low until well after the US unemployment rate falls below a threshold of 6.5%. But the policy will face challenges. Using cheap money to help sustain US economic activity will become trickier in the future. Further rises in longer-term bond yields will make it more difficult to keep official rates near zero.

The fragile five
As tapering continues, and asset purchases finally end shortly after mid-2014, planning a smooth strategy will become an increasingly tough challenge for the Fed under Janet Yellen’s leadership. If the withdrawal of monetary stimulus is mismanaged, there will be adverse effects both for the US and the wider global economy, notably for vulnerable emerging markets with big current account deficits. Some countries have already experienced unpleasant consequences as a result of tapering.

The “fragile five” (Turkey, South Africa Indonesia, Brazil, and India) have, in recent months, suffered speculative attacks against their currencies. These economies are significant global players, but, as US tapering continues during 2014 and bond yields rise, they will face increased threats of capital outflows and further currency falls.
In the eurozone, the most acute threats have diminished. The easing in financial tensions has been reflected in a narrowing of yield gaps between periphery sovereign bonds (eg Greece, Portugal, Spain and Italy) and German bunds. Retail sales are rising, and business surveys have been more positive recently. But it is premature to assume that the worse of the eurozone crisis is now behind us. The economy is still very weak. Growth slowed to a minuscule 0.1% in Q3 2013. Compared with a year ago, GDP is in negative territory.

Eurozone unemployment remained stuck in November at a record rate of 12.1%, and youth joblessness was 24.2%. The role of the European Central Bank in sustaining the economy remains critical, and president Mario Draghi reiterated his determination to maintain an accommodative monetary policy stance “for as long as necessary”. The fall in core inflation, which excludes food and energy, to a fresh low of 0.7% in December, has raised some worries that the eurozone may face a bout of Japanese-style deflation and stagnation. These concerns are exaggerated at present. But the ECB will be under pressure to ease policy further in the next few months.

Impressive recovery
The US recovery remains disappointing by historical standards, but there can be little doubt that economic performance remains impressive when compared to Europe and Japan. The US is more dynamic than other developed economies. The economy has benefited from the fact that the US has cleaned up its banking system more effectively in the aftermath of the financial crisis, and its banks are generally stronger than in many other countries. The US housing market continues to recover, with prices up 13.6% in the year to October 2013. Revised estimates show that US real GDP rose at an annualised rate of 4.1% in the third quarter of 2013, supporting the view that recovery is gradually gathering momentum.

The December 2013 job figures were disappointing, as only 74,000 new US jobs were created, well below expectations. The unemployment rate declined in December from 7% to 6.7%, but the fall reflected the fact that more people stopped looking for work. Nevertheless, the optimism over US prospects will persist. The December job figures were adversely affected by unusually cold weather. Upward revisions to previous estimates of job increases for October and November, totalling 38,000, support the view that the US labour market remains robust. In spite of the December setback, the Fed will continue with its policy of gradual tapering.

UK GDP growth for Q3 2013 was confirmed at 0.8%, but earlier figures were revised up markedly. Year-on-year Q3 growth was upgraded from 1.5 to 1.9%, supporting our view that, though growth has been weak, previous official figures have understated the UK’s performance since 2010.

In recent months, UK growth has been stronger than in all major European economies, including Germany. The UK labour market remains strong, and some commentators expect the 7% unemployment rate threshold, when the MPC will review its interest rate policy, to be reached well before end-2014. While this may be premature, it has created an unwelcome clamour in the media and amongst some City analysts for an early interest rate increase. Such a move would be unjustified at present, when the recovery is not yet secure. The MPC is unlikely to yield to pressure, and has stressed that reaching the unemployment rate threshold will not be an automatic trigger for higher interest rates. But repeated calls for a rise in rates will complicate the MPC’s job.

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