In the months since March, stockmarkets have recorded
remarkable increases by any historical standard. But these gains do not
necessarily foreshadow strong growth in real economic activity. The markets
remain deeply divided and uncertain. There are clear risks of setbacks both in
the real economy and in the financial markets.
But there are signs that the crisis is ending. Housing markets are improving.
Banking sectors are no longer facing imminent threats of collapse. Activity is
stabilising. Massive fiscal and monetary stimulus injected in the past year has
averted a precipitous collapse. But recovery is not assured. There are serious
dangers of a double dip.
As unemployment climbs to new highs, heavily indebted US and European consumers
cannot drive global recovery, but China and other emerging economies can help.
We have seen marked moves in this direction: the G20, not the G7, is now the
main global economic forum. But radical changes will not occur immediately.
China still refuses to revalue its currency significantly and will only
permit a slow restructuring of its economy towards consumer spending. Europe,
Japan and above all the US remain critical in the near-term and the risk of
relapse among them is high. Large trade deficits in the US and large surpluses
in Germany and Japan are major imbalances that have contributed to the crisis.
Sharp falls in the US dollar and sterling are part of the correction, but could
trigger new upheavals. If tensions between the main global players remain
unresolved, we risk unleashing a new crisis. In the face of huge budget
deficits and unprecedented money creation, governments and central banks are
uncomfortable. But the urge to adopt early exit strategies is dangerous. If we
tighten policy too early, we will cause a new recession.
Cutting public spending and raising taxes to bring public finances under
control will lower economic growth and reduce living standards. And longer-term
risks of inflation are very real.
Recession forces rate cuts, but inflation will return
Fears of financial collapse and concerns over deepening recession have forced
governments and central banks to concentrate on alleviating threats to jobs and
output, at the risk of higher future inflation.
As well as undertaking colossal banking sector bailouts, policymakers executed
major U-turns in their monetary policies. Central banks have been forced to
abandon the careful balancing of risks which usually guides their actions. The
most dramatic step so far was a co-ordinated 50 basis point cut in official
interest rates involving six major central banks including the Federal Reserve,
the European Central Bank and the Bank of England. Significantly, and unusually,
China cut its official rate at the same time.
Though it has not formally been part of the coordinated action, the
involvement of the Chinese underlines the seriousness of the global risks.
With recessionary pressures worsening, we expect additional interest rate
cuts, as well as more injections of public funds into various banking systems.
The Fed, having cut its key rate to 1.50%, is likely to move to at least 1.25%
in the next couple of months. The ECB defiantly and unwisely raised rates in
July to 4.25%.
Inflation is still high, well above official targets in most western economies.
The recent inflationary upsurge, driven by food and energy, is at its peak and
inflation will slow sharply in 2009. But government deficits will inevitably
balloon due to massive bank bailouts and the impact of deepening recessions on
public finances. The resulting large monetary expansion must eventually reignite
To alleviate the recession we must accept these consequences. But inflation
is not dead; it will resurface with a vengeance in the future and we will have
to fight it again in less comfortable circumstances.
Deceptive calm masks forex market threat
The markets are less tense, but display unusual contradictions. Share prices
have risen to new peaks. In normal circumstances this would signal optimism, but
stockmarkets display unrealistic hopes that the real economy would be
sufficiently weak to force the central banks into aggressive interest cuts
though not so dreadful as to throttle company profits. The recent 50 basis point
cut in the Fed funds rate to 4.75% and expectations of further reductions
underpin the better mood.
Revised figures show August US jobs figures were better than initially feared.
The US consumer is particularly vulnerable as the housing market deteriorates
and tight credit conditions make it difficult for households to borrow. With US
companies relatively robust and net exports improving, recession is unlikely.
But consumer weakness is dragging the US economy into a second year of
below-trend growth. Unemployment is set to rise and the Fed will have to ease in
spite of inflation risks.
The European Central Bank and the Bank of England left rates unchanged in
October, but both are moving to an easier stance. Interest rate increases are
now off the agenda, but with 2008 growth forecasts revised down, I expect
moderate interest rate cuts between now and the end of March: from 4% to 3.50%
in the eurozone and from 5.75% to 5.25% in the UK. In the UK, the fear is that
the crisis would harm the financial sector. Political opposition to euro
strength, threats of protectionism, and speculation could unleash disruptive and
damaging movements in the US dollar.
David Kern of Kern Consulting is chief economist at the British Chambers
of Commerce. He was formerly NatWest Group chief economist.
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David’s May 2008 feature setting out the three worst-case scenarios for the
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