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Economics Weekly - A year of economic recovery, but potential market volatility -- Weekly economic data preview - UK MPC minutes to shed light on divergent views?

Economics Weekly - 18 January 2010


A year of economic recovery, but potential market volatility


After the worst global recession since the end of the Second World War last year, the world economy is set to recover in 2010. What do consensus forecasts suggest for the economic recovery in the year ahead?


All of the G20 economies bar the UK - and it is due to report growth for Q4 - have posted positive gdp expansion in the second half of 2009. Hence it is clear that a widespread economic recovery is underway. This pick-up is a direct consequence of a massive, global co-ordinated fiscal and monetary loosening, mostly undertaken over the preceding twelve months. Some of that boost was unconventional, in terms of the direct and indirect help to financial markets and to companies. But the economic recovery remains fragile in some countries and though the policy loosening of the past year or so will have to be withdrawn, it will have to be done carefully. This is necessary so as not to derail the hard-fought, and costly, economic and financial market recovery now underway.


Not all countries are in the same phase of the economic cycle, however - some have had a worse experience during this global downturn than others. Indeed, some countries like China, Poland and Indonesia did not have a recession at all. This means that the global pace and extent of policy tightening will differ. For instance, Norway, Israel and Australia have already raised official interest rates, in some cases more than once. Other countries may stand pat all year on interest nrates but may withdraw other policy-loosening measures. This poses risks for the economic recovery in 2010, and implies a great deal of potential for financial market volatility during the year as policy changes unfold.


Table I shows that growth is expected to accelerate in all of the major economies this year and next. This is despite the rise in oil prices and the expected tightening of fiscal and monetary policy. Detailed forecast data show that the consensus expects consumer spending and industrial output to stage a recovery from the depressed levels of 2009, as world trade volume picks up strongly. Powerful forces for growth released by the cuts in policy interest rates, unconventional measures and fiscal easing will continue to boost economies well into 2010 and 2011. Moreover, the tightening of policy will take time to impact, meaning that the impetus to growth from earlier loose policy will outweigh the effects of its reversal for some time.


The fastest growing economies in 2010 will be from the emerging markets, just as in 2009 and, indeed, over the last five years on average. Of the countries shown in table 1, China leads the way. However, India will grow quickly as well and the other large emerging economies will also post growth than any of the developed economies both this year and next. Brazil for instance is expected to grow by over 5% this year.


What explains this out-performance of the emerging market economies? The potential for catch-up with developed economies is large given how poor these economies still are and that, combined with the adoption of modern capitalist methods of production and large under utilised labour markets, are unleashing strong gains in productivity in these emerging markets that will propel their growth rates for some time.


What does this recovery mean for price inflation in the year ahead? According to the consensus,

not much acceleration in inflation is expected to occur. Yes, there is some pick-up in price inflation from the low levels of 2009, but the acceleration is modest, see table 1. Indeed, Japan is expected to experience deflation this year and next. The reason for this is that the overhang of spare capacity created by the downturn will take some time to be used up. Typically, this could take 2-4 years or longer, depending on the pace of recovery from recession (since this recession is linked to a financial crisis recovery in output to pre-crisis levels could take even longer).


But, of course, policy has to be tightened ahead of this point to head off the return of inflation, and the consensus is showing this process underway this year. Chart b shows that although the consensus level of US short-term rates is expected to be second lowest in the chart, it is starting from a lower base than even Japan and so the extent of the tightening is greater. UK and Euro zone interest rates are roughly expected by the consensus to be at the same level by early next year. Bond yields in a year’s time are expected to be higher, though not by that much relative to where they are now and projected to be by April 2010.


The consensus currency expectations off the back of the economic changes seem to be pretty minor. Table 2 shows that the US dollar is expected to be weakening against the pound, slightly stronger against the euro, the Australian and New Zealand dollars, but flat against the Canadian dollar. This is remarkably stable and perhaps at odds with the implied change in short-term interest rates shown in chart b, though not with the change in longer-term rates.


Events of the past 3 years have shown that risks around forecasts of the year ahead can be very

large. So what should markets be worried about this year? First, the unwinding of the extraordinary cuts in interest rates, the use of unconventional measures and the tightening of fiscal policy are all likely to be major challenges for the year ahead. Leave policy too loose for too long and there is a risk of inflation and a return of asset price bubbles. Tighten too soon and there is a risk that the recovery stalls. Second, in Europe, the higher indebted economies of Ireland, Greece, Spain and Portugal may have a major adverse market reaction in 2010 if developments through the year prove disappointing. Third, there is a risk of protectionism, from a perception that some economies are not playing fair, by allowing their currencies to depreciate sharply. Four, oil prices are rising and there is a risk that this leads to higher inflation and weaker economic growth. Five, financial markets are recovering based on the current loose monetary and fiscal stance, but once this starts to reverse there is a risk that equity, bonds and credit markets could take fright.


So this is a year in which economic forecasts are particularly prone to error. However, a durable economic recovery does appear to be underway and financial markets are stable, a much better starting point than a year ago. For that we have to thank a global, coordinated and aggressive policy response in 2009.


Trevor Williams, Chief Economist, Corporate Markets


Editorial comments to:

Trevor Williams

Chief Economist

Lloyds TSB Corporate


Economic Research

10 Gresham Street

London, EC2V 7AE

Tel: +44 (0)20 7158 1748


Weekly economic data preview - 18 January 2010


UK MPC minutes to shed light on divergent views?


􀂄 The key focus in the UK this week is likely to stem from the minutes of the MPC’s January meeting. It is expected that the headline votes for an unchanged Bank Rate of 0.5% and for an unchanged Asset Purchase Facility (of £200bn) were unanimous. However, the detail may shed some more light on the diverging views for further a further extension to quantitative easing that appear to be emerging. The UK data calendar kicks off on Tuesday, with December CPI/RPI readings. We have pencilled in an unchanged CPI in the month, pushing the annual rate of inflation up to 2.3% from 1.9% in November. If realised, that would mean inflation averaged 1.9% in Q4, in line with the MPC’s November Inflation Report projection. The December claimant count (Wednesday) is expected to post a second consecutive monthly decline, staying on message with the REC jobs report, but headline average earnings growth will continue to look anaemic, with just 1.6% annual growth expected over the three months to November. December retail sales data are published Thursday. Survey data lead us to forecast a 0.5% increase in December sales volumes.


􀂄 In the US, the calendar is relatively light this week, with markets closed on Monday for the Martin Luther King holiday. Nonetheless, a number of releases are likely to garner attention, including the PPI, housing starts, leading indicators and, perhaps most importantly, the latest Philadelphia Fed manufacturing survey. The latter is one of the first indicators to give a flavour of how US economic activity has shaped up over the past month. Annual revisions published by the

Federal Reserve Bank of Philadelphia last week painted a more upbeat picture of US manufacturing conditions than initially reported, with December’s outturn revised up from 20.4 to 22.5. Nonetheless, we suspect the improvement was not sustained in January, with downside risks emanating from the fall in manufacturing payrolls last month and the possibility that the US inventory rebound is beginning to fade. Similarly, we expect the tone of the December PPI and housing starts reports to be relatively weak. With oil prices ending largely unchanged last month and the US dollar generally firmer, producer input prices are forecast to have fallen, while the headline finished goods PPI is forecast to have been broadly flat. Meanwhile, rising mortgage rates, the end of the tax credit programme and signs that house price gains are ebbing point to another historically weak set of housing starts data in December.


􀂄 Last week’s ECB press conference struck a fairly ‘cautious’ note on the likely economic recovery path in the euro area. The euro-zone economy emerged from recession in Q3 last year, propelled in part by exports and inventories. But these components are typically volatile, implying that quarter-on-quarter GDP outturns may move around significantly looking forward. But this is not necessarily being captured by business surveys from purchasing managers which have been on an almost continuous upward path since March. Preliminary euro-zone PMI reports for both the manufacturing and services sectors are published this week, where we look for readings of 52.0 and 54.0, respectively. Also published is Germany’s ZEW survey for January, where we envisage an outturn of 49.5 on economic sentiment (which gauges expectations), reflecting the pause for breath in stock markets over the past month or so.


􀂄 Elsewhere, Q4 GDP data for China are scheduled for release this week. The annual rate of GDP growth is forecast to have risen from 8.9% in Q3 to 10.9% in Q4, underscoring the remarkable resilience of the Chinese economy over the past year. Although China’s export growth was hit by the global downturn, this has been offset massive stimulus-led public spending and investment growth. The recent decision of the Chinese authorities to start tightening monetary policy further strengthens the view that economic activity over the final months of 2009 continued to improve.

Economics research team


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


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