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Economics Weekly - High global inflation has hit economic growth; Weekly economic data preview - BoE and ECB to keep interest rates on hold

Economics Weekly 1 September 2008


High global inflation has hit economic growth


With second quarter gdp data now available for the main economies, this might be a good time to look at how global economic growth has performed so far in 2008. Chart a shows that Q2 growth is currently much lower than in the year earlier in all of the major economies. Of course, the world economy has been hit by two major shocks in the last 12 months, the bursting of the credit bubble and a big rise in global inflation. Although the two effects are difficult to separate – both are at work to reduce the pace of economic activity - the sharp rise in price inflation appears to have more obviously hit household incomes, raised firms’ costs and led to weaker growth. Tighter lending conditions have intensified the slowdown. As a result of this, consensus forecasts for economic growth have been lowered sharply for this year and next, see charts b and c, mirroring the rise in forecasts of price inflation.


Economic growth has been revised lower…

We have been continually revising our forecasts for the global economy to reflect the worsening trend of recent economic data. Indeed, a scenario we carried out in May suggested that the biggest risk facing the world economy was higher than expected inflation, partly driven by rising oil and food prices resulting from fast growth in the emerging markets and loose monetary policy in the developed countries in the last five years. Unfortunately, events have moved closer to this more negative scenario for economic growth than in our central forecast at the time. However, it is still likely that the world economy will avoid recession, with the US showing tentative signs of also avoiding recession, but growth in the UK, Japan and the eurozone continues to weaken more than expected earlier in the year.


…as price inflation has proved sharply higher than expected...

Despite all the worries about the bursting of the credit bubble, and the initial assumption that this would lead to lower inflation as growth weakened - as individuals and companies were prevented from borrowing as much as they would like and so cut spending - it is ironic that it is, in fact, accelerating price inflation that has negatively impacted the real economy most severely in the last few months. It may be that the economic effects of the credit crisis are slow burning though the impact on banks and financial markets are plain to see. After all, the reduction in credit availability must be acting to weaken economic growth more than otherwise, but it is not enough to prevent price inflation from rising, at least in the short term, while the upward pressure from higher oil and food prices is so great. More worrying is the fact that core price inflation, which excludes the effects of energy prices and food, is also rising even as economic growth weakens.


Forecasts have been revised lower for 2009 as well…

Since the start of 2008, consensus forecasts of gdp growth have been revised lower around the

world and forecasts of inflation have been revised higher. As shown in charts b and c, the

upward revisions to inflation applies to all the major economies as are the downward revisions

to growth. And the same profile is repeated in 2009, with consensus growth for the US, UK and the euro area expected to be weaker than in 2008, though price inflation is expected to be

lower in each case. Our forecasts, in table 1, also show that global growth is weaker in 2009 than

this year, as higher global interest rates in 2008 to counter high inflation weaken the pace of economic activity with a lag. However, global growth is projected to bounce back to just above 4% in 2010, when most of the major economic areas see a recovery back to trend growth. For the UK, our growth forecast for 2008, at 1.4% is in line with the consensus, but our projection for 2009 is higher at 1.7% versus the 0.9% consensus. Despite this difference, what is clear is that UK economic growth in 2009 is likely to be well below the average rate of the last 10 years of 2.9%.


...but there is still a lot of uncertainty about forecasts for the year ahead

For the UK, and possibly the US, a sharp fall in the trade weighted index this year could boost manufacturing output in 2009 by enough to prevent growth from being below this year’s pace. Table 1 shows that economic growth in the emerging markets, though weakening in 2009, is still some 2 to 4 times faster than in the developed economies. The example of the US and UK in charts d and e illustrate quite clearly how inflation can hit growth. Higher price inflation reduces real wages (nominal wage inflation minus the rate of price inflation), unless wage inflation responds, though this can lead to an even more destructive cycle of a wage price spiral as one chases the other up. If wages do not respond, as seems to be the case so far, especially with growth so weak, lower real wages will lead to weaker disposable income growth and so to a reduction in consumer spending growth. As price inflation falls back in 2009, see table 1, some rise in real wages is likely and, as the relationship in charts d and e implies, some rebound in economic growth, is therefore likely. However, in our opinion, the peak in price inflation has not yet been reached and so the effects on growth are not certain. Although consensus forecasts have taken account of the likely inflation rise yet to come, one thing that is certain is that there are likely to be more revisions to economic growth and inflation projections in the year ahead. Moreover, history shows that the consensus view is rarely the most accurate.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview W/c 1 September 2008


BoE and ECB to keep interest rates on hold


The Bank of England and European Central Bank are likely to keep their key interest rates on hold on Thursday at 5.0% and 4.25%, respectively, as inflation rates in both regions continue to greatly exceed the official 2% target. The worsening backdrop for economic growth in both regions has not gone unnoticed but stable interest rates are vital if the two central banks are to succeed in bringing inflation back under control. The monthly US employment report will be under scrutiny on Friday as participants evaluate whether the rebound in Q2 gdp growth to 3.3% annualised can be sustained in Q3 and Q4. We forecast a rise in the unemployment rate in August to 5.8%. Interest rates in Australia could be cut on Wednesday for the first time since 2001.


• Aside from MPC member Blanchflower's comment last week that 'interest rates should be cut' and the downward revision to Q2 gdp growth to flat from +0.2%, we don't think UK economic trends have shifted enough since the Inflation Report in August to believe that a move in the BoE base rate is imminent. If anything, the fact that Mr. Besley stuck by his view last month of a need for higher interest rates testifies to the different views on the MPC as it worries about the course of inflation. A stronger than forecast gain in retail sales in July, +0.8%, and a 2-month high for the FTSE-100 last week are likely to convince the Bank that leaving interest rates at 5.0% is the best contribution it can make to ensure that inflation falls back to target. Whilst economic conditions in general remain tough and below trend gdp growth means that spare capacity in the economy should rise, the uncertainty of where CPI inflation will eventually peak against a backdrop of still very vigorous M4 money supply growth and a 12-year low for sterling (trade weighted) leaves no room for complacency. The MPC decision will be preceded by the key PMI surveys of manufacturing on Monday and services on Wednesday. The decline in both indices below 50 in Q2 was quite accurate in forecasting stagnation in economic growth. Given the ongoing concerns that tight credit and high inflation could tip the economy into recession - not our forecast - this week's data should offer some indication whether conditions are stabilising or deteriorating further at the end of Q3. More pivotal with regard to the near-term inflation outlook is the direction of prices. Last month, PMI surveys for the first time in three months signalled that output price pressures could soon stabilise.


• The US economy surprised many observers last week when Q2 gdp figures were revised up to 3.3% from 1.9%. This brings the average for the first half of 2008 to 2.1% annualised, far from recessionary conditions. With exports and personal consumption getting a lift from a weak dollar and the tax rebates, questions are now being asked whether the economy can sustain this rate of growth as the dollar strengthens and demand in overseas markets weakens. With unemployment also rising and personal income growth shrinking in July for the first time in 3 years, households could be more inclined to save. The August employment report is due on Friday and is forecast to show a rise in the jobless rate to 5.8% from 5.7% in July. Average earnings growth and details on hours worked are valuable to understand if wages are growing and how order books and productivity trends are changing working hours. The ISM surveys of output in manufacturing and services sectors will be published on Tuesday and Thursday. The ADP employment survey is due on Wednesday and may show a 2nd consecutive gain in private employment.


• The report last Friday of a decline in euro zone CPI to 3.8% in August from 4.1% in July will be welcomed at the ECB but is unlikely to materially change the Bank's tone on Thursday when it meets on interest rates. We are not convinced that the result heralds the start of a rapid decline in CPI back towards 2%, and are equally concerned that the upward trend in core inflation may delay or prevent a more substantial drop in headline CPI in the months ahead. With growth still forecast to recover later this year, we expect the ECB to retain a neutral bias on interest rates on Thursday when it will also publish its latest forecasts for growth and inflation for 2008 and 2009.

Kenneth Broux, Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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