Events in North Africa and the Middle East, along with the build-up of inflationary pressures, have finally started to disturb the financial markets’ complacent confidence that global growth will inevitably accelerate.
Share prices have fallen only slightly from their recent highs and remain at elevated levels that can only be justified if you are prepared to shrug off mounting risks, but the earlier upward momentum is now facing growing resistance. The cheerful mood is increasingly being mixed with a much-needed dose of scepticism.
The possibility that things can go wrong is not yet the dominant view, but it is no longer dismissed out of hand. Market reaction to the US labour market figure, a key monthly indicator, illustrates the more sombre mood. The weak and disappointing January employment report was shrugged off and share prices continued to rise, but the much stronger February employment figure was given a cool reception, and both the stock market and the US dollar weakened.
The financial markets believe that the new risk of a global oil shock is a major concern.
Over the past six months, oil prices have increased by almost 50 percent. Political turmoil has accelerated the pace, but crude prices have been moving up sharply for economic reasons even before recent events raised fears about oil supplies. Even without major disruptions, there is a risk that much higher oil prices will produce an unpleasant mixture of weaker growth and higher inflation. The GDP forecast shown in the table below is based on the assumption that the oil price (using Brent crude as the benchmark) will average some $100 a barrel. Even if Brent crude rises to $120 a barrel, the global recovery will probably continue, albeit at a slower pace. But much larger price increases, to $150 a barrel or higher, will undoubtedly cause a major setback. The risk of global stagflation is now much greater.
Central bank response
The differences of opinion between the major central banks on how to react to higher inflation are intensifying. In Asia, growth in many economies remains too fast and monetary policy will be tightened further. China has increased interest rates twice in the last three months, and has repeatedly raised bank reserve requirements to restrain lending. Many other developing Asian economies such as Indonesia, India, South Korea and Vietnam have also raised rates. At the other extreme, Japan was still facing deflation before its devastating earthquake and tsunami and had said it would continue keeping rates at just above zero for some time. But the policy gap between the US and Europe is becoming more acute.
The US economy created 192,000 new jobs in February, a respectable increase, and the weak January figure was revised upwards. The US unemployment rate fell to 8.9 percent, the lowest in almost two years. The stronger jobs market mainly reflects a surge in private sector employment, which rose by 222,000 in February. The figure is important politically since it reduces the risk of a jobless US recovery, but it is unlikely to persuade the Federal Reserve to alter its expansionary stance.
However, the US recovery is still fragile. GDP growth in the fourth quarter has been revised down to 2.8 percent annualised. More worryingly, house prices are still falling, and this will force consumers to retrench. Although the fiscal situation is risky, and there are signs that US inflation is edging upwards, the Fed is likely to continue stimulating jobs and growth: it will keep its key policy rate at 0-0.25 percent until Q3 2011 at the earliest, and will implement its $600bn quantitative easing plan. But if job prospects improve further, there will be no need for the Fed to launch additional quantitative measures after June.
In the eurozone, it was known for some time that the European Central Bank (ECB) is increasingly uneasy with rising inflation, which reached 2.4 percent in February, above the target of just under two percent. The ECB left rates unchanged at its early March meeting. But president Jean-Claude Trichet warned that “strong vigilance” was needed in the face of mounting inflationary pressures. These words were often used in the past as a signal that interest rates would be raised soon. The market now expects an increase from one to 1.25 percent in April or May.
Such a move would be appropriate for Germany and other “core” economies where growth is relatively strong, but it could pose acute dangers for weak countries in the eurozone periphery. The renewed speculative attacks on Portugal highlight the dilemma facing the ECB: if it raises rates, it risks worsening the sovereign debt crisis.
Pressures for early tightening are also building up in the UK. With inflation now at four percent – double the official target and set to rise further in the near term – three out of the nine members of the Monetary Policy Committee (MPC) voted for an immediate increase in rates at the latest meeting.
On present trends, two additional MPC members will probably join the hawks soon, and the markets now expect that a majority will vote for an increase in rates when the MPC meets in May.
The concern with inflation is understandable. However, UK inflation is largely driven by international factors. Wage pressures are still modest, and raising rates while fiscal policy is being tightened would risk derailing the fragile UK recovery. While UK rates will have to increase later in 2011, it would be safer to wait until the initial impact of the austerity plan has been absorbed.
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