Having fallen off a cliff at the turn of the year, the global economy is getting back to its feet. After the Japanese, German and French economies grew in Q209, the other major industrialised economies – the US, the euro area, the UK – look set to follow suit in Q3. And after accelerating in Q2, China’s economy is steaming further ahead, outpacing the government’s target.

This is, of course, a far better outcome than many feared in the wake of the decision to allow Lehman Brothers to collapse. And this is largely due to the actions of central banks and governments. Ultra-low interest rates and unlimited liquidity are easing the process of de-leveraging, as households, companies and financial institutions repair their balance sheets. Unprecedented government support for financial entities prevented a further collapse of a major financial institution. Unorthodox quantitative and credit easing policies have pumped funds directly into the economy, supporting confidence and mitigating financial sector blockages. At the same time, governments’ massive fiscal packages – with G20 countries’ discretionary stimulus measures worth about 1½% of GDP this year alone and fiscal ‘automatic stabilisers’ worth a similar amount on top of that – have supported activity, directly via higher public spending and tax cuts, and indirectly via incentives for private spending such as the popular ‘cash-for-clunkers’ car scrappage schemes. 

While the end of recession in most countries is cause for celebration, in no way have the major economies returned to normal. Almost everywhere, the vast amount of spare capacity lingering from the downturn precludes a rapid or strong turnaround in private investment. And unemployment still has further to rise, weighing on the outlook for consumption. In countries where the private sector overstretched itself in the pre-crisis ‘boom’ years – notably the US and UK, but also Spain and Ireland in the euro area – de-leveraging will also continue to weigh on private demand, possibly for several years. And growth in many of the countries which avoided the pre-crisis excesses – including Japan and much of the euro area – will remain relatively subdued given their heavy reliance on exports as a driver of growth.

The recoveries in the industrialised economies will therefore be modest and highly reliant on continued fiscal and monetary policy support. Having recently updated our global forecasts, we think that, of the major industrialised economies, the US will register the strongest growth – of around 3% - next year, largely because the fullest impact of its fiscal support will be felt then. But, as and when its public sector largesse is withdrawn, the US economy could well struggle to grow above its potential rate. GDP growth in most other industrialised countries will remain at or below trend rates through to at least 2011, and those economies will struggle in the absence of prolonged supportive macroeconomic policy.

While headline inflation is set to pick up as the base effects of past sharp energy price movements wear off, wage growth will remain weak, and excess capacity will exacerbate underlying disinflationary pressures. And so, underlying inflation will undershoot central bank targets at least into 2011 and probably beyond. Therefore, we do not expect any significant move to tighten monetary policy for several months. We expect the US Fed to be the first to raise interest rates, in mid-2010, once unemployment has peaked, but the pace of further tightening thereafter will be gradual. Meanwhile, the sluggishness of the euro area growth outlook suggests that the ECB will leave rates unchanged until the back of end of 2010. We also do not expect the Bank of England to raise rates within the next twelve months, while the Bank of Japan is likely to maintain its ultra-low rates into 2012 and possibly even beyond. We also do not expect any central bank to sell any of its assets purchased under quantitative/credit easing policies, with central bank balance sheets most likely to contract gradually and of their own accord as bank demand for funds diminishes.

Chris Scicluna, Head of Economics

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