A waiting game

The OECD sounded cautiously optimistic when it published its latest economic outlook in the middle of September. “Banks appear to have recognised most of the losses and write-downs related to sub-prime based securities,” it said. Yet within days, Lehman Brothers had slumped into bankruptcy protection, Bank of America had stepped in to bail our Merrill Lynch – buying it for about €35bn, half its value a year ago – and AIG was asking the Federal Reserve for a €28bn bridging loan.

That, of course, is the risk of making forecasts in such turbulent times. No doubt the irony of the timing was clear in Nice, France, where the EU's finance ministers just happened to be holding a get together. At the top of their agenda: how to respond to financial turmoil and economic downturn.

The ministers decided to provide extra lending for small firms but ruled out public spending on the large scale seen in the US, which has spent €70bn on tax rebates in an effort to spur economic growth. The EU's public lending arm, the European Investment Bank, is going to double the loans it makes available to small and medium-sized companies, which, because of the credit crunch, are finding it harder to secure finance from commercial banks. It will lend around €30bn over the next three years.

“We're not simply adopting a ‘wait and see' policy, we are not going to sit on our hands,” said French Economy Minister Christine Lagarde, who was hosting the event. “We need to make sure that our economies perform well.” Indeed they do, as the economic outlook for the Eurozone is bleak.

Inflation remains the policy priority, as ECB President Jean-Claude Trichet pointed at after the meeting. Soaring oil and food prices have pushed inflation up in the past year. The annual rate of Eurozone inflation hit a record four percent in July but has since eased a little after oil prices retreated from a high of more than €103 a barrel. The ECB has refused to reduce interest rates – which would encourage growth, but could also push up inflation. Its last move was to increase rates to 4.25 percent from four percent, on the grounds that inflation had to be tamed.

It'll be interesting to see whether the ECB sticks to its strict line on rates. In April, the consensus view among policymakers was that Europe was not at risk of recession. With hindsight, that was hopelessly optimistic. Three days before the ministers got together in Nice, the European Commission cut its Eurozone growth forecast for this year to 1.3 percent from the 1.7 percent it predicted in April. It forecast growth of 1.4 percent for the broader EU group – including those, like the UK, that do not have the euro. That's a big drop on the two percent it predicted in April. One reason for the change of heart is that, since April, gross domestic product in the Eurozone has shrunk – the first time the eurozone has experienced a quarter of GDP contraction since it was created in 1999.

Recession recession recession
That means the Eurozone is on the brink of a recession – it just needs another quarter of GDP shrinkage to fulfill the technical definition. However, the Commission is clinging to its optimism. It still forecasts that the overall Eurozone economy will stagnate rather than contract in the third quarter – although at national level it predicts that Germany will dip into a brief recession, followed by Spain and the UK.

Indeed, recession for some EU states seems now inevitable, even if its politicians refuse to use the word, for fear of making things worse (“Germany is not in a recession but in a downturn,” German Finance Minister Peer Steinbrueck told journalists in Nice).

Elsewhere, there is a willingness to face reality. Before setting off to Nice, the UK delegation had to digest a new economic forecast from the Confederation of British Industry, an influential lobby group. It said the UK would slip into recession in the second half of 2008 – albeit a “shallow” one – and that growth in the economy in 2009 will be the lowest since 1992.

It downgraded its growth forecast for 2008 from 1.7 percent to 1.1 percent and said economic output would shrink by 0.2 percent quarter-on-quarter between July and September, followed by a further 0.1 percent decline in the fourth quarter.

Its good news was that GDP should stabilise early in 2009 ahead of a gradual and growing recovery, with quarter-on-quarter GDP growth reaching a near-trend rate of 0.6 percent by the end of next year. Nevertheless, for 2009 as a whole, the GDP growth forecast has been cut from 1.3 percent to 0.3 percent.

Better news is that it expects inflation to peak at 4.8 percent this quarter, and thanks to an easing in commodity prices and the weaker economy, to fall back rapidly over 2009, reaching close to the Bank of England's two percent target by the fourth quarter (2.3 percent). There is even a significant risk that, into 2010, inflation will undershoot the bank's target.

This cheery view of the inflationary outlook should allow the Bank of England to make a series of rate cuts, bring the base rate down to four percent by next spring. “The bank should have leeway to cut interest rates and, as inflation falls, we should be well placed to move beyond this difficult stage in the business cycle,” said CBI director general Richard Lambert. “If all goes well there should be room for a half point cut in November to help restore confidence in the beleaguered economy.”

That's if all goes well. “Over the past year our forecasts for economic growth have been shaved lower and lower as the UK economy continues to struggle with the twin impact of higher energy and commodity prices and the credit crunch,” Lambert added. “Having experienced a rapid loss of momentum in the economy over the first half of 2008, the UK may have entered a mild recession that will hopefully prove short lived. This is not a return to the 1990s, when job cuts and a slump in demand were far more prolonged. The squeeze on household incomes and company profit margins from higher costs will begin to ease as the price of oil moves downwards and, although the credit crunch will be with us for some time, conditions are set to improve later in 2009.”

Dark outlook
The CBI believes that UK unemployment will break the two million mark in 2009, reaching 2.01 million and a jobless rate of 6.5 percent. Average earnings growth is expected to remain subdued, which will aid the improving inflation outlook. Sharp rises in fuel and food costs, the resulting decline in real incomes and the troubled have undermined consumer confidence and dampened household spending, and the CBI predicts that household consumption will contract by 0.3 percent in 2009.

Forecasts for investment have been downgraded, with fixed investment now expected to shrink by 3.5 percent in 2008 and by four percent next year, compared with flat growth predictions in the last CBI forecast. Much of this decline comes from the weak outlook for investment in buildings, as both residential and commercial property markets continue to struggle.

Is this relative optimism justified? The OECD's global headline trends seem to be improving, but its forecasters are very cautious about making predictions right now. “Limited experience with some of the main drivers of the current conjuncture as well as uncertainty about some specific influences make for a particularly unclear picture,” it says, which roughly translated means: we haven't seen anything like this before and we don't want to come out of it looking like idiots.

Nevertheless, the OECD does venture that in the euro area and its three largest economies, as well as in the UK, economic activity is foreseen to remain broadly flat. More widely, Japan will see only a partial bounce-back and the situation in the US is still tough to call.

Globally, the OECD says financial market turmoil, housing market downturns and high commodity prices continue will continue to bear down on growth. “Continued financial turmoil appears to reflect increasingly signs of weakness in the real economy, itself partly a product of lower credit supply and asset prices,” it said. “The eventual depth and extent of financial disruption is still uncertain, however, with potential further losses on housing and construction finance being one source of concern.”

The downturn in housing markets is still unfolding, with reduced credit supply likely to add to the pressure. US house prices continue to fall, threatening further defaults and foreclosures that may again depress prices and boost credit losses. As regards construction, however, there are some hints of eventual stabilisation with permits and sales of new homes having ceased to fall and inventories of unsold houses coming down. In Europe, downturns in prices and construction activity appear to be spreading beyond Denmark, Ireland, Spain and the UK, with sharply lower transaction volumes a precursor of downturns elsewhere.

On commodities, the OECD notes that the price of oil has fallen from peaks reached around the middle of the year in response to slower demand growth and record production from OPEC. Oil supply conditions remain tight, however, contributing to volatile prices. Prices of other commodities – notably food – appear to have steadied at high levels. Food commodity prices may ease in the period ahead as droughts end in some food-exporting countries and as higher food production comes on stream.

On inflation, the OECD says that sharp increases in energy and food prices have boosted headline rates and sapped real incomes of consumers across the OECD area. Statistical measures of underlying inflation have also drifted up in most large OECD economies, partly reflecting the ongoing feed through of higher commodity prices. Wage increases have been broadly contained, so far. Its prediction: “If commodity prices are sustained at their recent, and in cases such as oil, lower levels some moderation of both headline and underlying inflation is to be expected.”

What should policymakers do in this tough climate? Pretty much what they are doing now, according to the OECD. In the US, underlying inflation is high but appears not to have drifted up further. The continuing credit crunch justifies Washington's efforts to boost the economy with tax cuts. In the eurozone, underlying inflation has been rising steadily for some time, suggesting that capacity pressures need to be reduced, says the OECD. A recession would achieve that nicely, so there is no need to change policy. If action were needed, the OECD would rather see interest rate cuts than higher spending or tax reductions.

The message seems to be this: politicians and policymakers in the US, the eurozone and elsewhere have done all they can to avoid a deeper economic crisis. Now we just have to cross our fingers and wait.

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