A Bad Hangover from 2008
Post-war recessions in the US have lasted ten months on average, so the current contraction is already longer than the norm, having begun in December 2007 according to the body that dates the US cycle. On that basis one might turn to thoughts of recovery, but as yet there are few signs that we have reached bottom although the futures market is priced for the onset of modestly higher US interest rates by the end of 2009.

The fourth quarter of last year was particularly dire, not just in the US but across the global economy, perhaps exacerbated by the Lehman collapse. We know that Q4 GDP fell by 1.5% in the UK and a broadly similar decline is likely to be recorded for the US, with a steeper contraction possible in the euro area.

This has significant implications for average growth rate figures in 2009, as it provides for very negative carry-over effects, and as a result the consensus growth forecasts for this year are being cut sharply, both for the major economies and the global economy as a whole. The European Commission, for example, now expects euro zone GDP to decline by 1.9% although such is the impact of the carry-over effect that four consecutive quarters of flat growth will still leave the annual average at -1.3%.

Two factors normally help to precipitate recovery – lower inflation and looser monetary policy. The former is certainly underway, helped by the plunge in oil prices in the second half of 2008, with headline inflation set to turn negative in the US and UK in the coming months, which will provide a strong boost to real incomes. Monetary policy too, has turned supportive, with official rates now near zero in the US, 1.5% in the UK and 2% in the euro area, and the market expects more to come from the ECB and the Bank of England.

Yet the dysfunctional nature of the global banking system means that the normal transmission mechanism for monetary policy is impaired, which adds a greater degree of uncertainty about the duration of the recession and the timing of a recovery. This impairment has prompted the incoming Obama Administration to consider a $850bn fiscal package (6% of GDP) and some central banks to explore more direct ways of stimulating bank lending and lowering effective rates for borrowers.
In the US this “credit easing” is already underway and the UK has also now embraced the concept, including purchases of corporate debt and a scheme to provide insurance to banks on further loan write-downs. The ECB does not have this freedom of manoeuvre however, given the unique structure of the euro (which government bonds would it buy for example, and what nationality of corporate bonds?) so any green shoots of recovery are more likely to emerge elsewhere, and probably in the US.

Dr. Dan McLaughlin.