AS 2012 gets off to a rocky start, the situation is dangerous and the outlook grim. Fears that the eurozone’s sovereign debt problems may unleash a new global banking crisis forced the major central banks to take pre-emptive measures. Risks that the euro may disintegrate in a disorderly manner have become acute. Europe’s growth prospects have worsened.
In the face of these threats, the financial markets have been surprisingly complacent in December, with share prices regaining virtually all their November losses. But the cheerful mood is likely to prove short-lived, since the market rebound is not based on firm foundations.
In a co-ordinated move with other major central banks, the US Federal Reserve cut the penalty interest rate it charges commercial banks on US dollar liquidity from 100 to 50 basis points. The surprising initiative was taken to alleviate pressures on European banks, as the inter-bank market has ceased to function smoothly. The central banks’ wider aim was to avoid a global liquidity crisis, and the positive response supported share prices.
But the situation has not returned to normal, though inter-bank market tensions have eased. Providing more liquidity to the banks is helpful but it doesn’t deal with the fundamental problem, which is the need to address the worsening solvency resulting from the sovereign debt crisis. The very fact that the central banks found it necessary to act in a dramatic manner highlights the depth of their concern.
Hopes that a new EU summit will finally resolve the euro’s problems are unrealistic. Chancellor Merkel and president Sarkozy signalled determination to tackle the crisis, but they were unable to hide the gap between their respective positions. While Merkel wants a legally binding fiscal union to enforce discipline, France is reluctant to give up control over its budget and prefers inter-governmental agreements it can veto. Given Germany’s dominant position, its view will probably prevail.
But a comprehensive fiscal pact is unlikely to emerge, and it remains to be seen if a partial deal will satisfy the markets. Germany will probably veto the issuing of eurozone-wide bonds. However, if there is agreement on more discipline, the Germans may ease their opposition to aggressive purchases of periphery bonds by the European Central Bank (ECB).
Measures that effectively entail fiscal transfers from strong to weak euro members remain anathema to the German electorate. Without such moves, however, debt crises will become more frequent and threaten the euro’s survival. Unfortunately, periphery economies such as Greece and Spain will continue suffering from a huge competitive gap, even if fiscal discipline improves. This can only be closed by a prolonged squeeze on real wages, which will be very difficult to sustain.
Meanwhile, the eurozone economy is deteriorating. The unemployment rate rose in October to a euro-era peak of 10.3%, and analysts now expect to see negative growth in the last quarter of 2011 and early 2012. Many hope that a eurozone recession will be “mild” and relatively short. But the risk of a more severe downturn is serious. Though the 3% eurozone inflation is well above target, the ECB will have to act more forcefully to minimise the threats. Having cut its key policy rate from 1.5% to 1.25%, the ECB will soon announce an additional cut to 1%, and will also reluctantly move towards more quantitative easing.
Even China is showing distinct signs of slowdown. Though GDP grew by 9.1% year on year in the third quarter of 2011, a spectacular pace by western standards, the purchasing managers’ index fell in November to a level indicating that Chinese manufacturing is contracting.
This was the first outright fall in activity for almost three years. The worse-than-expected purchasing managers’ figure forced the authorities to reverse the tight policies they have pursued until recently. To counter threats to growth, the Chinese central bank initiated a surprise easing in monetary conditions by cutting the banks’ reserve ratio for the first time in three years. The fact that Chinese inflation fell in October to 5.5%, and is expected to continue declining, will make it easier for the Chinese authorities to reduce the reserve ratio further in the next few months. Though the key policy rate will not be cut in the near term, earlier plans to raise rates will be abandoned.
The US is also continuing to expand more strongly than Europe. Though US growth is mediocre, many key indicators have been better than expected. There are negative features: continued stalemate over the budget and a weak housing market, with prices down 3.6% year on year in September and 31% below their 2006 peak. But there have been positive developments: the US created 120,000 new jobs in November, and the unemployment rate fell to 8.6%, the lowest since March 2009. The purchasing managers’ indices for November point to modest but steady US growth. Falling US inflation will make it possible for the Fed to persevere with low interest rates. A further dose of quantitative easing remains a distinct possibility.
In the UK, the Autumn Statement confirmed the grim outlook that is facing the economy. Growth forecasts have been revised down and public borrowing will be higher than predicted. To protect the UK’s triple-A credit rating, the government will have to persevere with its tough deficit-cutting plan. But the austerity measures will have to continue for two years longer than planned. As inflation is now past its peak, and likely to fall sharply in 2012, we expect an early additional increase in quantitative easing to £325bn. Official UK rates are likely to stay at 0.5% at least until the first quarter of 2013. ?
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