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Economics Weekly - 2008 was a year of shock and awe for the world economy; Weekly economic data preview - Fed and weak data put pressure on central banks to slash rates

Economics Weekly 22 December 2008

 

*The next Economics Weekly is published on 12 January 2009. We wish all our readers a Happy Christmas and a prosperous New Year*

 

2008 was a year of shock and awe for the world economy

2008 has been a year full of tumultuous events for financial markets, with the failure of some of the brightest names in the banking sector and wholesale government rescues being mounted for most of the rest. Low financial market volatility, a feature of the last seven years, turned into one of the highest periods of volatility ever experienced in some markets. The boom in the world economy has come to an abrupt end and now seems a distant memory. But at the start of the year, there was some optimism that while economic growth would slow, outright recession would be avoided. Now, the world economy faces the worst recession since the 1980s. Inflation was not seen as a major problem at the start of 2008, but by the end of the year deflation and disinflation were the main concern.

 

Economic forecasts for 2008 were almost uniformly wrong…

Consensus forecasts show that expectations for economic growth in 2008, made in December 2007, were way too optimistic. Chart a illustrates that the latest (December 2008) projection for growth this year has turned out to be sharply lower for every country included. Such was the growth momentum at the start of 2008, however, that although all of the countries in the chart are now in recession, none of them will see an outright fall in gdp this year; that will come in 2009, when all of them will see a fall in output. For the UK, economic growth is on course to turn out less than half what was the expected increase. For Japan, economic growth will turn out to be two-thirds less than predicted at the start of the year.

 

…economic growth, inflation, interest rates were all thrown off course…

This deterioration in the growth performance is occurring despite lower short term and long term interest rates in all of the major economies than was expected at the start of 2008. Charts c and d highlight how much interest rates, short and long term, have collapsed. But short term rates are measured using interbank quotes, and these are much higher than official benchmark lending rates due, of course, to the ongoing credit crisis. If short term rates are analysed in terms of official levels, they are in most cases at or below historic lows, because these economies were at the epicentre of the credit crisis, except Japan whose banking sector has not been as badly hit by it directly.

 

Despite weaker economic growth, consumer price inflation has turned out higher than forecast, see chart b. Indeed, consumer price inflation has been higher in all of the economies projected than was expected, as economic growth in the first half of 2008 turned into outright declines in output in the second half. This is testament to the ferocity of the turnaround that has occurred in the global economy in 2008 ending, in the case of the UK, 16 years of uninterrupted growth and one of the longest and strongest expansions in the world economy since the Second World War. Oil and commodity prices played a decisive role in pushing up inflation, so reducing real incomes and hence hitting economic growth. For instance, oil prices rose to a peak of $147 a barrel in July before subsiding to around $35 at present. As a result, the economic forecasting record was not great last year for anyone, but then the demise of famous companies that had survived for hundreds of years and the effective failure of the global financial system does not occur too often either.

 

…because of one of the worst ever financial market crisis…

The year started with fears that the credit market crisis, which had begun in Q3 2007, could spill over into price deflation and economic crisis. However, chart e shows that credit market and stock market risk perceptions, as measured by the Vix volatility index, were stable, albeit at a much higher level than in the previous 5-7 year period. But in the second half of the year with the bankruptcy of Lehman Brothers (a 150 year old firm), the rescue of all of the top US investment banks and a host of other financial market companies, as Fannie Mae and Freddy Mac also went into explicit public ownership, confidence went into a nosedive. This is shown in charts f and g, where stock markets crashed lower and the dollar fell sharply against some currencies but gained against most others. However looked at, 2008 was as fundamentally a defining moment in economic and financial markets history as any in previous generations, and it is not yet over as we enter 2009. Many of the issues and challenges posed in 2008 are persisting into 2009 - with some sort of resolution possible for some of them, one way or another - but not necessarily for all of them.

 

 

Weekly economic data preview W/c 22 December 2008

 

Fed and weak data put pressure on central banks to slash rates

The historic decision by the US Fed to cut interest rates to a range of zero to 0.25 percent and the commitment to keep them at exceptionally low levels for some time has raised pressure on other leading central banks to follow suit and further reduce interest rates. Following the Fed's move last week, the BoJ cut rates to just 0.1%, the Norwegian central bank slashed them 1.75% to 3% and the Danish central bank by an unexpected 0.5% to 3.75%. Recent data also suggest the economic slowdown is intensifying, while the threat of deflation continues to mount. We expect the BoE and ECB to cut interest rates by up to 1% in January, to potentially 1% and 1.5%, respectively. As the room for further cuts diminishes, we also expect more unconventional measures, such as 'quantitative easing' -directly boosting money supply, to target ongoing strains in credit markets. As expected, the calendar is relatively light over the main holiday period for key data, however the risk of important policy announcements is still quite high. Thin volumes and 'year-end' also raise the potential for volatility. The week starting 5 Jan should see trading volumes and general market activity pick up sharply, helping to underpin prices.

 

In the UK, we expect confirmation this week that the economy shrank by 0.5% in the third quarter of 2008, while the first view of the balance of payments data is forecast to show the current account deficit narrowed to £10.6bn in Q3, from £11bn in the second quarter. While the gdp data may be revised slightly, the recent disappointing PMI indices for manufacturing, services and construction suggest the economy may have contracted by over 1% in the final quarter for the first time since the start of the last recession in 1990. The risk of an excessive fall in the exchange rate led the BoE MPC to decide against cutting Bank rate by more than 1% earlier this month, however another sharp reduction in January may be unavoidable, taking official interest rates to the lowest on record. Despite the sharp fall in sterling over the past year, the UK's goods trade deficit has stayed close to £8bn, mainly reflecting slowing external demand. However, the current account deficit in the first half of the year was over £10bn smaller than in H1 2007, primarily reflecting a sharply higher income surplus. Nevertheless, the deficit still represented 3% of gdp in Q2 and the risk is that it widened in the third quarter, which could put further downward pressure on sterling. Next week, there are some key data published on Friday. The November lending to individuals figures are forecast to show housing market activity remained constrained and modest growth in consumer credit. The manufacturing PMI may have fallen further in December, from a survey low of 34.4 last month. The BoE decision, on Thursday, provides the highlight in the first full week of 2009, with the services PMI and manufacturing data on either side of it likely to show falling output. Producer prices data, on Friday, may show further sharp falls in December.

 

The focus in the US in the weeks ahead will remain on credit market developments, with discussions still ongoing with the major auto companies over the final terms of the bailout and the Fed adding to its rapidly expanding balance sheet. Data are likely to show further signs of economic weakness, with this week's personal income and spending numbers for November watched particularly closely for indications of how sharp the overall gdp contraction may be in the final quarter. Ahead of these figures, other data should confirm the economy shrank by 0.5% in Q3 and again underline the fragile state of the housing market. Next week, the consumer confidence and ISM manufacturing indices are likely to show weak outturns in December, with both potentially falling below last month's readings as general conditions have deteriorated. The December labour market report is due on 9 January. Weekly jobless claims data suggest another fall in the region of 500,000 in non-farm payrolls is likely, while the unemployment rate is forecast to edge up closer to 7%.

 

Recent data from the euro zone show the economic slowdown is intensifying and has added further pressure on the ECB to lower interest rates. The next regular monthly meeting is on 15 January. Data in the coming weeks will confirm the growing impact of the credit crisis on the real economy, while also highlighting the ebbing threat of inflation.

Jeavon Lolay, Senior Economist

 

Economic Research,
Lloyds TSB Corporate
Markets,
10 Gresham Street,
London EC2V 7AE
,
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www.lloydstsb.com/corporatemarkets

 

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