Gaining traction
31 March 2010
While financial markets spent much of the past quarter fixated on the unfolding fiscal crisis in Greece, the global economic recovery continued. Most of the world’s major economies had emerged from recession by the third quarter of 2009, while Q4 saw the recovery gather momentum. Of the major developed economies, growth in the fourth quarter was strongest in the US, while the Japanese economy also enjoyed a rapid rebound from a disappointing Q3, helped by a further acceleration in Chinese growth. And, having been the slowest of the G7 economies to emerge from recession, even the UK economy finally posted positive growth in the fourth quarter. The weakest growth performance was seen in the euro area, where the economy expanded just 0.1% on the quarter. Nevertheless, with several emerging economies, particularly in Asia, also seeing strong demand at the end of 2009, the global economy looked to be on the road back to sustainable growth.
But while recovery has taken hold in most of the G7, its underlying strength remains fragile. For all economies, the huge amount of spare physical economic capacity that persists will inevitably weigh on the pace of investment growth. The damage done to labour markets and household balance sheets, meanwhile, will continue to weigh on household consumption for years to come. And while some countries, notably Japan, are enjoying rapid growth in overseas demand, that is not the case for the other major economies. So, with private demand growth stunted in the wake of the recession, we continue to expect the recoveries in the industrialised economies to be both unimpressive and highly reliant on continued policy support.
Our latest economic forecasts see the US registering the strongest growth, but recent softish data mean that we now expect growth to be slightly below the 3% level we expected three months ago. At the other end of the spectrum, we have also revised our growth forecast for the euro area lower, and now expect growth of just 0.7% in 2010, with growth strongest in the core economies and weakest in the peripheral economies. Growth in Japan, meanwhile looks set to slow in the near term, picking up in H210 as the labour market strengthens and private sector investment builds. For the UK, we still expect a very sluggish recovery.
These growth forecasts imply that a huge degree of spare capacity will persist for the foreseeable future. So, while headline inflation rates have risen across the industrialised world in the wake of higher energy prices, core inflation has and will remain more restrained. Given this, while the world’s major central banks, with the exception of Japan, are slowly running down the liquidity support put in place at the height of the crisis, monetary policy in the G7 looks set to remain highly accommodative and we remain some way from tightening by any of the central banks. The February FOMC statement maintained the language in place since March 2009, specifically stating that officials expect to keep the federal funds rate at an “exceptionally low” level for an “extended period”. As such, we don’t expect the Fed to begin moving away from its ultra-accommodative stance, either through an increase in the interest rate it pays on reserves and/or an increase in the FFR, until the end of this year at the earliest. The ECB, having recently extended its policy of full allotment at its liquidity auctions until the autumn, has effectively ruled out an increase in its refi rate until 2011. The BoJ is likely to come under pressure to do more to support the economy. And, having in March increased the amount of funds available under the special liquidity facility it introduced in December, we expect the BoJ next to extend the maturity of the funds available under this facility from three to six months. The BoE, meanwhile, is unlikely to raise rates over our forecast period, and may well feel the need to provide further support to the economy, probably via another increase in gilt purchases.
The fragility of the recovery means that the risks are heavily weighted to the downside, and hence to much later tightening by central banks. Perhaps the biggest risk comes from the looming removal of fiscal support to economies across the globe. Given the explosion in government debt stocks seen over the course of the crisis, fiscal support will begin to be withdrawn from 2011 onwards. If private demand at that point is not sufficiently strong to take over the reins of growth, a policy-induced double-dip would be on the cards. Over-hasty or over-ambitious fiscal tightening is therefore the most significant downside risk facing the major economies.
For government bond markets, with inflation and policy interest rates set to remain at very low levels for some time, we expect major bond yields also to remain low. However, as the US recovery gains traction towards mid-year and expectations of rate rises by the Fed build, yields will rise, with continued supply concerns adding to the upward pressure. Rising US yields, along with improving economies elsewhere, will result in rising yields in other markets too. But, in Japan, with deflation set to persist for the foreseeable future and the BoJ likely, if anything, to loosen monetary conditions further over the near term, any rise in JGB yields will be capped and JGBs will outperform. In forex markets, meanwhile, any move by the BoJ to extend the maturity of its special liquidity operations should reinforce the position of the yen as the cheapest funding for carry trade purposes, helping to weaken the yen. The euro, on the other hand, should regain some of the ground it has lost this year, although concerns about the problems in the area’s peripheral economies continue to pose a risk for the euro.
Grant Lewis, Head of Economic Research
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