The global economy is losing steam
Friday, September 10, 2010
, Posted by Usman Ali Minhas at 8:55 AM
- Setback. Our picture of a W-shaped economic recovery after the Great Recession appears to be materializing. The expiration of the fiscal packages running into the billions and the reversal of the inventory cycle are now increasingly slowing the pace of global growth. Consideration is being given to new stimulus programs, first and foremost in the US.
- US. The slowdown there started as far back as this spring and will, moreover, be more pronounced than originally anticipated. There is the growing fear that the economy will slide back into recession. We would not go that far, but we are making a downward revision to our growth expectations for 2010/11 (pages 4-7).
- Fed. It is not only the US administration that intends to stimulate again. The central bank has announced its intention to prevent a further shrinking of its balance sheet. Consequently, we do not expect the first rate hike until the beginning of 2012.
- EMU. The European economy is holding up pretty well. This appears to confirm what ECB economists discovered as far back as 2009: The US cycle is feeding through to Europe less strongly and above all later than in former years. But here too, the slowdown is inevitable. The rapid pace of growth reported this spring cannot be maintained. For 2010/11, we expect GDP growth of 1.6% and 1.3%, respectively (pages 8-9).
- ECB. A slide back into recession is, however, improbable, with the result that the central bank could really lean back and continue its exit from the ultra-expansive monetary policy – were it not for the resurfacing concerns about the solidity of European banks and the rapid sovereign bond spread widening (cf. Weekly Comment, pages 2-3).
- Further topics:
– Switzerland: House price inflation a concern for the SNB (page 10).
– Commodities: Precious metals still on top (pages 14 & 17).
– Data outlook: ZEW growth expectations trend lower; US consumers become more skeptical (page 20).
– Market outlook: Bonds well supported; euro to weaken (page 26).
Under pressure again
Once again, the euro area looks like it’s bursting at the seams, barely a week after ECB President Trichet argued confidently that the differences across member countries are perfectly normal for such a large economy. Trichet quoted growth and unemployment data for individual eurozone countries and individual US states to illustrate the inevitable comparison between the two largest economies: his point was that the heterogeneity challenges faced by the ECB are no more serious than those confronting the Fed.
Yet the last few days have focused attention on another set of figures which tell a different story: the spread of 10Y Greek government bonds versus 10Y German Bunds has surged to about 10 percentage points, about the peak reached just before the “shock and awe” EU/IMF stabilization package launched last May; the corresponding spread for Ireland has jumped well above its previous peak, at about 3.7%, and spreads on Portuguese government bonds have also reached a new record, at about 3.5%. It is a stark reminder of why regional differences matter more for the ECB than for the Fed: if peripheral countries remain under such pressure, the ECB will have to buy more of their bonds.
In the “adverse loop” between banking sector concerns and sovereign debt fears, this time the causality seems to run from the former to the latter: the latest widening in sovereign bond spreads has been triggered by evidence that Irish banks are again under pressure, compounded by a Wall Street Journal article which argued that the stress tests did not reveal the full extent of the banks’ exposure to sovereign debt. Portuguese banks have been tapping ECB liquidity to the tune of close to EUR 50bn – far less than Ireland, but still a substantial amount. Spain and Italy have suffered significantly less, but have not been immune. Overall, the eurozone seems to be now paying the price for its less than perfect handling of the stress tests: the latest news and developments seem to suggest that the euro-zone banks will need substantially more capital than the puny EUR 3.5bn amount which resulted from the stress tests.
Differences in the macroeconomic outlook of periphery and core Europe have therefore not been the main driver of the latest spread widening. But as the eurozone’s recovery loses some steam in the months ahead, the especially weak growth outlook of the most vulnerable periphery countries will come under closer scrutiny, as it complicates the fiscal adjustment currently underway. The ECB should perhaps welcome a deceleration from the torrid pace of growth seen in the second quarter, as it might help mute some of the incipient tensions and disagreements that are beginning to emerge within the Governing Council, where last week’s decision on liquidity measures going forward was taken by consensus rather than with unanimity. The ECB has its hands tied, for the time being: as long as tensions in the banking system and in sovereign debt markets persist, it will have no choice but to keep supplying abundant liquidity and to remain engaged in the secondary market for periphery sovereign bonds. Last week, the ECB was able to pay lip service to the idea of a gradual normalization and unwinding of its enhanced credit support policy, by allowing the 12-month and 6-month liquidity auctions to expire as expected, and by shifting the 3-month auctions to a flexible rather than fixed rate. But the bottom line remains that the bank will continue to supply unlimited liquidity up to a 3-month maturity.
While the ECB has signaled that interest rate moves and liquidity provisions are in principle independent, suggesting that if needed the bank could move to hike rates even while flooding the market with liquidity, this would be awkward – and in my view, it would be inconsistent as well. It is therefore a blessing in disguise that macroeconomic conditions remain sufficiently weak to almost certainly rule out a re-awakening of inflation pressures over the policy-relevant horizon. And to the extent that governments continue implementing their gradual fiscal consolidation programs, there will be broader support for a protracted accommodating monetary stance.
Nevertheless, a nagging doubt should remain in the minds of many Governing Council members: for how long is such an extraordinarily loose monetary stance justified and prudent? Even as the pace of the recovery decelerates, growth will be settling at a pace that might seem lackluster but is in line with the eurozone’s similarly lackluster potential (a “normal” which for the eurozone is not even that “new”). And if the growth outlook has normalized, the only justification for the still extremely loose monetary policy can be given by the persisting dislocations in money markets and sovereign bond markets. Having conceded this, though, we have to also recognize the risk that a monetary policy which is as loose as in the worst phase of the recession might eventually cause its own distortions if it is maintained once the real economy is back at potential growth. From this standpoint, it would be prudent for the ECB to gradually unwind the stimulus. The longer it finds itself unable to do so, the more the Governing Council should grow uneasy. I would therefore expect and hope that, behind closed doors, the ECB will intensify its pressure on governments to address the remaining pockets of weakness in their banking sectors, to keep up fiscal consolidation, and to accelerate those structural reforms which could help reduce the cross-country differences which otherwise threaten to widen further.
