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 â€“ 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 firmsâ€™
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
Economic growth has
been revised lowerâ€¦
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.
â€¦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
Forecasts have been
revised lower for 2009 as wellâ€¦
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 yearâ€™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.
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.
â€˘ 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.
â€˘ 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.
â€˘ 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.
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