Concerns over the US economy have been the financial markets’ main drivers for months now. Earlier in the summer, the main effect was to push down government bond yields towards the very low levels seen when the recession was at its worst.
More recently, the focus has shifted towards currencies. The US dollar has plunged, and the euro has surged to a six-month high.
The key trigger was the Federal Reserve’s dramatic signal that it is seriously considering injecting a further dose of quantitative easing. In plain language, this means it will purchase more government bonds and other assets in order to increase money supply, boost bank liquidity, put downward pressure on interest rates and help to support economic activity. One of the key tools for achieving these aims is a weaker dollar.
The exchange rate can be critically important for jobs and real economic activity. At a time when many economies are suffering from recession and high unemployment, currency movements can be politically explosive and can cause major international tensions. When demand is weak, devaluations can boost exports and help create jobs. But, regrettably, not everyone can devalue at the same time.
If most major global players plan to recover on the back of export-led strategies, dangerous competitive devaluations can erupt.
Until the crisis blew up in 2008, the US was effectively acting as the world’s “importer of last resort”. Its trade deficit helped the Americans enjoy an unsustainable consumer boom, while simultaneously enabling China, Germany, Japan and a few other economies to accumulate huge surpluses. But this model cannot be recreated. The US will be forced to reduce its deficit by financial market pressures and, more significantly, by the political imperative to stimulate growth and create jobs.
It is premature to predict a new trade war. Many still remember the trade bust-ups of the 1930s, which helped transform a recession into an appalling depression.
Self-interest should stop countries from being driven to the brink.
But one cannot ignore some worrying signs. Japan is intervening to curb the
yen’s rise for the first time in more than 35 years. There are strong rumours that South Korea, Singapore, Taiwan and Thailand intervened to halt their currencies from rising. China has only allowed limited increases in the value of the yuan, and Stateside critics continue to accuse it of manipulating its currency. With the US unemployment rate still stuck at 9.5 to 10 percent, the November mid-term congressional elections will increase US protectionist pressures. Global
tensions will inevitably worsen if the recovery falters again.
The evidence points to a marked US slowdown starting in the third quarter of 2010. But fears of a major decline appear overstated. Many US figures, though disappointing, were better than expected. GDP rose at an annualised rate of 1.7 percent in the second quarter of 2010, well below the 3.7 percent growth in the first quarter, but better than the earlier estimate. Even the weak US housing market, which many see as a major threat, has performed better than expected, with surprisingly strong housing starts.
The euro has soared in recent months. After falling to $1.19 at the height of the Greek crisis, the euro rose above $1.37 in early October, a net appreciation of more than 15 percent. Since the European Central Bank (ECB) is the only major central bank that is unlikely to inject additional quantitative easing, the euro is set to rise further in the near term.
But this stellar performance is ominous for a eurozone economy. Recent bailout packages have eased the sense of crisis, but underlying threats endure. Yield gaps between German bunds and the eurozone periphery remain very high. Banking sector weaknesses have escalated.
The lack of competitiveness facing periphery countries such as Spain, Greece and Portugal will persist and threaten the single currency’s future. The euro’s surge heightens the dangers of a new crisis erupting some time in the next one to
two years. When this happens, the euro will fall back.
The table of interest rates, opposite, which includes for the first time forecasts for 2012, summarises the key feature of our “central forecast”. Compared with 2010, growth will weaken in 2011 and 2012, both globally and in most major economies.
On balance, we believe a double-dip recession will be avoided. But risks of a setback are high, and monetary policy will have to remain expansionary, particularly in those countries planning to implement forceful budget cuts. As Table 2 shows, we expect official interest rates in the US, UK and Japan to only start rising in Q3 2011 at the earliest. The ECB rates may start going up a little earlier, in Q2 2011.
In the UK, average growth will be higher next year than in 2010, but this is largely a statistical quirk, because of weak UK growth at the turn of this year.
In quarterly terms, UK growth will slow very sharply from the early months of 2011, as VAT goes up to 20 percent and the coalition government starts implementing its tough fiscal austerity programme. To avert a setback, we expect the UK to increase its own quantitative easing programme.
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