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Economics Weekly - Will the credit crunch help ease global imbalances? Weekly economic data preview - Focus on UK CPI inflation, German ZEW survey and US data


Economics Weekly  14 April 2008

Will the credit crunch help ease global imbalances?

Credit crunch forces IMF to revise down growth forecasts…
Without a doubt, the credit crisis has the potential to really set global growth back quite substantially. In its latest Global Financial Stability Report, the IMF sets out how this could happen. And in the latest IMF World Economic Outlook, its revised growth estimates detail the impact the credit crunch will have on the world economy. The IMF has lowered its global growth forecast by ½% to 3.7% for 2008 but the biggest effect will be on the U.S. The IMF cut its forecast for US growth in 2008 to just 0.5% from 1.5%; for the UK to 1.6% from 1.8% and the euro area to 1.4% from 1.6% previously.

Interestingly, these changes leave the UK as the fastest growing out of this group. However, the main issue is that the IMF is now more pessimistic about global growth as a result of the severity of the credit crisis than it was in the last report in December 2007. But it is also true that its forecast for the emerging market economies shows a downward revision to economic growth of just 0.2%, to 6.7% in 2008. So this means that its 1 percentage point reduction in US growth for this year has barely impacted the growth of the developing economies. This is a big change from the past, but that is not our main focus in this note.

...but a silver lining could be that slower US growth will help to reduce global imbalances that in
time would have resulted in a more severe crisis

Our main focus is on the fact that the effect of the credit crisis, in forcing the US to grow more slowly (and others to adjust to that) and in reducing its trade and current account deficit, is effectively raising the US savings rate. This could be one of the few bits of good news that comes out of the credit crisis, because it helps to reduce one of the key global imbalances that the IMF has warned in the past had the potential to derail the world economy. Indeed, such a correction might have had an even greater impact on the global economy than the credit crisis appears to be exerting, because it might have hit the emerging economies harder.

US and UK have been saving too little, consuming too much…
What do we mean? Effectively, the US has been consuming too much or saving too little for about a decade. This is shown in chart a, where the current account deficits of the US, UK, EU and Japan are compared in terms of their percentage of economic output, or gdp. The point is clear: the US, and in fact the UK also, have been seeing a drift further into deficit, with Japan increasingly in surplus and the eurozone economy’s external trade in balance. This implies that the UK and the US have been consuming more goods than their trading partners, in other words saving too little. Of course, it also suggests that Japan as a whole has been saving too much. The implications of this for exchange rates in trade weighted terms are very clear; the dollar has been falling and the yen has been rising, the euro is at around its fair value and sterling is currently falling, see chart b. These shifts are in line with what economic theory would suggest, see charts c and d. Growth in the countries with the large external deficits needs to slow relative to those economies in surplus and or the exchange rates of the deficit countries must fall. The more extreme the imbalance, the more extreme will be the movement in the exchange rates of the economies concerned.

…but fall in the $ & £ and slower growth is helping to restore balance
Our analysis shows that the US trade weighted index is the lowest it has been on record and that the UK’s trade weighted index has fallen by 12% since the peak in 2007. The fall in the US trade weighted index seems to be narrowing its external imbalance and so reducing its share of gdp, though there is a long way to go to achieve balance (the deficit is still over 5% of gdp) so the currency may remain weaker than it otherwise would for some time. Unfortunately, the level of the UK’s external deficit relative to the size of the economy has grown and suggests sterling could fall even further before stabilising.

…this may be the only silver lining in the credit crisis
Hence, insofar as the credit crisis ensures that the UK and US economies’ growth rate will slow, the inevitable correction in external imbalances that would have occurred at some point in the future seems to be happening now. This is possibly one silver lining in the severe negative impact that the credit crisis is having on the developed economies. It appears not to be affecting the emerging much at this time. By occurring now, at a time that the emerging market economies are growing faster than the global average and the developed countries, see chart e, the potential for the US and the UK to export their way out of difficulty is much improved. But this does assume control of price inflation risks implied by the sharp fall in the value of the US$ and UK£. In other words, the US and UK authorities must accept slower, but more balanced growth (away from consumption and towards manufacturing and exports), rather than higher inflation that would stem from efforts to maintain consumer spending through too low interest rates.

Trevor Williams, Chief Economist


Weekly economic data preview W/c 14 April 2008

Focus on UK CPI inflation, German ZEW survey and US data

Following the reduction in interest rates to 5% by the Bank of England last week, attention will shift to economic data to assess the scope, if any, for further policy easing. UK CPI inflation and labour market data will be the key releases, while the BRC retail sales monitor will provide an early look at March retail sales. Retail sales were strong at the start of the year, unemployment remains at 30-year lows and CPI inflation is set to rise in the coming months. In the euro area, the key release will be the German ZEW survey and the final estimate of EU-15 March CPI, neither of which will provide room for the ECB to cut interest rates. The US calendar is busy and includes inflation, retail sales and industrial production, as well as the Beige Book and the NY Fed Empire and Philly Fed business sentiment surveys.

• It is not going to get any easier for policymakers on the Bank of England Monetary Policy Committee (MPC). The Bank has already cut interest rates by a total of 0.75% to 5% since December, in response to slower economic growth expectations and widening spreads between market interest rates and Bank rate. Yet, with CPI inflation currently above target at 2.5%, slower growth is actually necessary to reduce inflationary pressures. Indeed, although CPI is expected to be steady in March, it is set to accelerate above 3% in the second half of the year (see chart 1 below). Moreover, notwithstanding weaker business and consumer confidence surveys, "hard" data in the form of retail sales and manufacturing output have been robust in the first two months of the year. So, despite the credit crisis, economic growth may well remain around trend in Q1. Therefore, claimant count unemployment is forecast to fall again, by 3,000 in March, keeping the rate at a 33-year low of 2.5%. The BRC retail sales monitor will provide an early indicator of March retail sales and the extent to which a further slowdown in the housing market, as the RICS survey is expected to show, is affecting spending - it has not dampened spending so far. Doves on the MPC will point to wage growth which is expected to remain benign. However, inflation expectations remain elevated and what should be further temporary rises in CPI inflation later this year risks becoming entrenched. Hence, given these inflation risks, it is by no means clear that the Bank will cut interest rates further this year, unless the economy took a turn for the worse.

• The ECB left interest rates unchanged at 4% last week. We maintain our long held view that there is no room for lower interest rates in the euro area. Eurostat is expected to confirm that the headline rate rose to 3.5% in March, well above the ECB's target of "below but close to 2%". In fact, ECB President Trichet admitted that it may be another 18 months before inflation falls back to target. The German ZEW survey's main outlook index fell to a low of -41.6 in January but has since risen to -32 in March. We expect another rise to -31. Importantly, this survey of investors has been over-pessimistic relative to "real" economic data. Chart 2 shows that EU-15 industrial production has remained relatively robust despite the soaring euro and weaker global economic growth prospects.

• The slate of US economic data next week is likely to confirm that the Fed will cut interest rates again later this month, but probably by only a quarter point to 2%. The reason is that inflation is becoming an increasing concern for the Fed. Indeed, last week saw a sizeable 2.8% monthly rise in import prices on the back of higher commodity prices. We expect both headline and core annual rates of inflation, due next week, to rise to 4.1% and 2.5%, respectively. The NY Fed Empire and Philly Fed surveys have painted a bleaker picture of the US economy than the ISM manufacturing survey and "hard" data. Nevertheless, we expect a slight improvement in these surveys. The retail sales and industrial production figures, also due, should confirm slowing economic activity, but a slowdown that is not as severe as the recession of 2001.

Hann-Ju Ho, Senior Economist

Economic Research,
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