World growth is slowing...
The global economy is slowing down. And some countries could have a recession - or two consecutive quarters of negative growth - including the UK. After world growth of 5% on average in the last four years, the fastest sustained period since the early 1970s, the rate of expansion is set to ease to 4% this year and to 3.5% in 2009. This growth slowdown would imply a need to lower nominal interest rates but action like that by the monetary authorities would be wrong, and perhaps be a huge policy mistake. The reason is that real interest rates - nominal interest rates deflated by price inflation - are too low at a global level. What do we mean by this?
...but perversely monetary policy is still too loose at a global and regional level...
When real interest rates are below real long run average growth, the monetary policy stance can be said to be expansionary and contractionary when above real growth. Following on from that, low real interest rates therefore generate upward pressure on inflation, as growth is pushed above its long run average, while high real rates create downward pressure on inflation, as growth is pushed lower. Real interest rates are a good guide therefore to whether monetary policy interest rates are too loose or too tight. We have calculated real interest rates for the global economy, and this shows that they are presently too loose, in fact negative, encouraging upward pressure on price inflation. This needs to be tackled. The question is how?
...this is shown by the fact that price inflation is accelerating and real interest rates are negative...
World inflation is accelerating, driven by higher commodity prices and too strong a rise in global demand, but also by a loose monetary stance. This may seem odd, since the credit crisis implies a squeeze on the availability of money and so in theory a tighter policy stance. But that is true only in some countries and, even there, it is not the whole story. The excesses of the credit boom were caused by a too loose monetary stance and its consequences therefore suggest that a return to those policies is neither possible nor desirable nor in fact sustainable. The sharp rise in global inflation is a sign that inflation problems are not confined to one country or region but are a worldwide phenomena and issue. Ignoring rising global inflation would put at risk the achievement of fast global growth that low inflation has brought about. Chart b shows that it was the fall in global inflation that led to lower nominal interest rates and hence a rise in the pace of real growth and its improved sustainability. This achievement risks being lost if inflation is allowed to rise too rapidly.
...including in the major economies hit by the credit crisis
In many countries, from the US to India and China, inflation is at 15 to 20 year highs or more. And chart a illustrates why this is, in the key economic areas, developing and developed, real interest rates are negative. For inflation to fall, real interest rates need to be positive, as the experience of the high global inflation period shows that low real interest rates generate high price inflation. Chart c shows this point more clearly that, currently, real rates are too low in some of the major economies of the world. The good news is that they are still not as low as the level experienced in the 1980s and early 1990s, but will continue to push inflation higher if not reversed. Expectations, using consensus forecasts, suggest that monetary tightening will occur next year. The problem is that it still leaves real interest rates well below their average since 2000, and worse, the rise in real rates only occurs because of falling price inflation. Forward markets suggest that interest rates are expected to be cut in the UK and eurozone. Only in the US are they raised, and then from a very low, and unsustainable, nominal rate of 2%. This is not the case everywhere, of course, and nominal interest rates are being raised in the large emerging markets, but the key question is whether this is enough at the global level? Hence, the danger is that inflation does not remain low as real interest rates are still low after falling next year so that price inflation then accelerates again in 2010 and beyond as growth recovers. Charts d, e and f illustrate strikingly, just how negative real interest rates are in the US, UK and eurozone and how much they have to rise just to get back to the average since 2000, never mind to a tight stance.
The question is will monetary policy be tightened enough to squeeze inflation for more than just a year?
What needs to be done therefore is for real interest rates to rise. That can be accomplished by a combination of falling inflation and by a rise in nominal interest rates. But for price inflation to fall for a sustained period, nominal interest rates must be raised so that real rates are tightened further. In some parts of the world this is already happening but weak growth and the credit crisis has meant this has been half hearted, especially as slower growth hits employment and the poor hard. However, rising inflation erodes real incomes and leads to a longer period of slow growth than if policy responds aggressively in the near term. This is shown by the historical fact depicted in chart b that continued low inflation generates positive effects that lead to long periods of sustained high real growth. However, there are limits to the rate of economic expansion. Beyond that point, excessive inflation is triggered, and the level of real interest rates suggests that too easy monetary policy has now helped to bring that about.
There are also other ways of toughening the overall policy stance, by allowing exchange rates to appreciate, though this is not a global solution, and by tightening fiscal policy, but at the heart of it must be a sustained rise in real interest rates. Unfortunately, this may mean the unpalatable outcome of higher, not lower, nominal interest rates in a number of major developed economies in the future.
Chart a: Global interest rates are negative in all major economic areas
Chart b: Low global inflation has generated high and stable economic growth
Chart c: Real interest rates are forecast to rise, but perhaps not by enough to quell inflation
Chart d: The UK's real interest rate has been falling but still positive for now though below its average
Chart e: The US real interest rate has fallen sharply and is already negative
Chart f: Rising inflation has pushed euro zone's real interest rate sharply lower
Focus on US growth this week
The second estimate of annualised US Q2 GDP may be revised up to 2.8% from 1.9% as factory orders, retail sales and net trade in Q2 have either been revised higher or exceeded expectations since the first release. The July core PCE deflator is likely to have increased by 2.4%, remaining above the Fed's 2% preferred rate. Also, the Fed publishes the minutes off its 5th August FOMC meeting. Inflation data are also published by the EU-15 - the August forecast is for growth of 4.1%, more than double the ECB's target. With the downward revision to zero from 0.2% growth in UK Q2 GDP, the GfK consumer confidence, the distributive trades' survey and the latest Nationwide house price survey may provide further insight into the likelihood of UK recession in Q3. Japan is likely to publish an improvement in industrial output and retail sales in July, adding to the debate about the country's growth path.
UK financial markets are closed for the Bank Holiday on Monday. Last week's downward revision to flat quarterly Q2 GDP growth (+0.2% first estimate), 1.4% (1.6%) on an annual basis, will increase focus on indicators that may be reflective of GDP performance in Q3, including the possibility of recession. The CBI distributive trades' survey may improve to -30 in August from -36 in July, but still significantly weaker than the 12-month average of -2, signalling that higher costs and weaker sales are weighing on profit margins. GfK consumer confidence could deteriorate further, from -39 in July to -41 in August, as rising utilities charges and food costs and the negative impact of falling house prices on household wealth weigh heavily on sentiment in the consumer sector. Following Rightmove's publication of a record 4.8% drop in house prices in August, the Nationwide house prices survey may show double digit declines following July's 8.1% drop in annual terms, adding to the housing market gloom.
The US Q2 GDP second estimate may show that the economy outpaced the initial growth forecast - an upward revision from 1.9% to 2.8% is likely. (See chart 1 for regional GDP trends.) In addition, July monthly growth of personal income and spending may come in at a robust 0.1% (0.1% in June) and 0.3% (0.6% in June). The Chicago PMI index for August may also improve compared with July, suggestive of a better factory performance. The upward growth revision and some survey evidence of improvement so far in Q3 may strengthen the argument that the US economy bottomed out in Q4 2007 and that subsequent data point to recovery. This, together with the likelihood of a rise in the core PCE deflator, the Fed's preferred inflation measure from 2.3% in June to 2.4% in July, is cementing perceptions that the Fed will soon start normalising the level of interest rates. (Chart 2 shows rising CPI inflation in the major economies.) Other data published this week includes existing home sales, which may have risen from 4.86m in June to 4.92m in July and new home sales which may stabilise at around 0.53m, adding to the view that the US housing market may be over the worst. S&P /Case Shiller house prices for June are also important - the market consensus is for a decline of 16.2% (- 15.8% in May). Finally, we will be looking to see whether or not initial jobless claims again total over 400,000 this week, indicative of a soft labour market.
The EU-15 publish a plethora of economic data releases to add to the debate about whether the region will enter technical recession or return to quarterly growth in Q3. The German ZEW survey improved in August, so we will be looking to see whether or not the German IFO business survey strengthened as well - we expect a slight improvement to from 97.5 in July to 97.9 in August. The PMI business survey results suggested EU-15 business confidence may be stabilising, but still remains at levels suggesting output contraction. Another key data release is the preliminary August CPI figure, which may rise from 4.0% in July to 4.1% in August, more than twice the ECB's 2% target. Other releases include money supply growth, the unemployment rate and EU-15 consumer and industrial confidence surveys.
Chart 1: Growing contrast between GDP trends - the US (early signs of recovery) and the UK/ EU-15 (signs of recession)...
Chart 2: ...but the US, the EU-15 and the UK are experiencing well above target CPI inflation
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