The third of a three-part report looking at how major countries are faring in the global downturn, what they're doing to combat the weakness, and when they might recover
From Standard & Poor's RatingsDirectThis is the third of three parts.
In most regions, inflation has fallen sharply from its 2008 levels, largely on sharp declines in oil prices. Most countries are seeing rapidly falling inflation rates, also known as disinflation. However, several countries are dangerously flirting with deflation—or outright falling prices. On the brighter side, the unexpectedly rapid slowing in total and core consumer prices adds to the already ample leeway the central banks have to keep rates low.
Consumer prices in the U.S. are flat from a year earlier, the first time this has happened since 1955. Moreover, core inflation (excluding food and energy) in the U.S. decelerated to 1.7% in the 12 months ended January 2009, compared with 2.5% last January and well below the Hurricane Katrina-related 2.9% peak in October 2006. The core chain-weighted CPI, which is closer to the core consumer expenditures deflator the Fed tracks, is up 1.2% from a year ago and at the bottom of the Fed's comfort zone of 1.5%-2%. We expect core CPI to moderate to 1.1% in 2009 as slowing growth further eases price pressures. After its Jan. 27-28 meeting, the Federal Open Market Committee (FOMC) for the first time said that "inflation could persist for a time below rates that best foster economic growth and price stability in the longer term." In our view, inflation pressures in the U.S. will likely remain subdued. Deflation is the greater risk right now.
In Japan, the long battle against deflation had appeared to be over. However, commodity price declines brought Japan's CPI down to just 0.4% in December 2008. Given the bleak economic landscape, it's possible that it could return to negative territory in 2009.
Inflation for Continental Europe and Britain also dropped sharply in January on lower energy prices. However, the risk of real deflation still appears small in these regions. More likely, they're experiencing substantial, yet temporary, disinflation. In Canada, we project CPI to decelerate to 1.0% in 2009 from 2.4% in 2008, mostly because of commodity prices.
The direction of inflation is a key issue in other regions as well. For example, high inflation in Korea earlier prevented the Bank of Korea from lowering interest rates even though growth began to moderate. In January, however, CPI slowed to 3.7% over last year and is well below the July 10-year high of 5.9% year over year. This gave the Bank of Korea room to cut its primary interest rate aggressively, even though inflation at 3.7% is substantially higher than the Bank of Korea's 3.0% target inflation rate
In Australia as well, uncomfortably high inflation pressures last year have receded. They're likely to ease further on the back of weaker global growth, slackening domestic demand, moderating wage pressures, and lower food and oil prices. In Australia, we project CPI to decelerate to 2.2% in 2009 from 4.5% in 2008, mostly because of commodity prices.
Oil Prices Make a U-Turn
After reaching a peak of $147/barrel in July 2008, oil prices have abruptly fallen 70% to about $40/barrel in January 2009, which helped support spending—such as it is—in most regions that don't produce their own oil. Nevertheless, oil remains a wild card for the world economy. Although the risk has abated, supply disruptions in the Middle East could spark another surge in prices above $100/barrel, making the current economic slowdown in most regions that much worse. We expect oil at yearend to be about $43/barrel. However, our confidence in that forecast isn't strong.
A few years ago, many economists believed that a global recession would occur if oil held at more than $70/barrel. However, the world economy has survived far higher prices, not without a scratch but certainly with more limited damage than feared. This is largely because wealthier countries have become less dependent on oil than in the past. For example, during the last big spike in 1981, energy accounted for 14% of U.S. gross domestic product. Today, it's only 8%. Per capita energy use in the U.S., Europe, and Japan has been essentially flat over the past 35 years, while incomes have more than doubled. Still, even in a more energy-efficient world, higher oil prices remain a risk to global growth.
The Lenders of Last Resort
Since last year, foreign and U.S. investors have become obsessed with credit risk, which sharply increased borrowing costs and sent the real economy into a free fall. Because of the U.S. subprime mortgage problems and related instabilities in the international capital and financial markets, central banks have taken dramatic action to stabilize these markets. Moreover, heightened recession risk has led to more policy rate cuts.
After raising the federal funds rate 17 times through August 2007, to 5.25% from 1%, the U.S. Federal Reserve had to reverse course. Often in coordination with several major central banks, the Fed has cut rates almost 525 basis points (bps), to its current near-zero level, a historic low.
The Fed's current economic projections suggest that it has little fear about keeping interest rates low for the foreseeable future, which we expect to be at least through the summer of 2010. The Fed will want to see the impact of the measures it and other central banks have taken to reduce the turmoil in credit markets. Lower oil prices and reduced core inflation allow them more time.
The Fed is at the end of rate cuts because it can't drop the federal funds rate below 0%, but it will continue to use policies aimed at pushing credit into individual lending markets. The new plan for the remaining $350 billion in TARP funds focuses on providing banks with capital. Speaking before the Senate Banking Committee on Feb. 24, Fed Chairman Ben Bernanke declined to call the aid "nationalization," electing to instead refer to it as a "private-public partnership." There is a risk that the Fed will end up becoming the banking system as it makes more loans itself or leans on banks harder to do so. But it is difficult to see an alternative for now.
The Bank of England (BoE), the European Central Bank (ECB), and the Bank of Canada (BoC) also had to abruptly change direction. The BoC put its easing policy on hold last spring. However, signs of slowing income growth and spending amid deteriorating financial conditions and a weak U.S. outlook forced the bank to resume its easing program, lowering the overnight target rate 200 bps, to 1.0%, with more cuts likely to follow. After holding rates at 5.0% through September 2008, the BoE cut them by 450 bps to 0.5% though March 2009, the lowest in the bank's 315-year history. The BoE will likely keep rates at 0.5% through 2009.
The ECB had maintained a hawkish stance through late 2008, raising rates to 4.25%. However, the shutdown of credit markets after the Lehman Brothers collapse forced its hand. In a globally coordinated move, the ECB cut rates by 50 bps on Oct. 8, 2008. It continued slicing to 1.5% through March 2009, the lowest ever. With inflation running lower, that will allow the ECB the opportunity to cut interest rates again. Standard & Poor's expects the ECB rate to hit 1.0% by April.
Other major central banks also cut rates sharply. The Bank of Japan (BoJ) policy board cut the target overnight call rate 40 bps, to 0.10%, at its meeting last December. The bank also lowered its economic growth estimate and abandoned language calling for higher interest rates in its half-yearly outlook report. Since September, the People's Bank of China has cut the one-year base lending rate five times, to 5.31% by late January. Falling inflation rates allows for more rate cuts through 2009.
The Reserve Bank of India cut its key interest rate (repo rate) by a cumulative 350 bps, to 5.5%, since the start of an easing cycle in October and announced other various growth-stimulating measures. Again, declining inflation gives it the ability to pursue these policies.
Rising inflation in Korea through the second half of 2008 prevented the Bank of Korea from reducing rates, even as growth began to moderate. However, increased economic risk forced the central bank to cut rates aggressively by 300 bps, to 2.0%, between October 2008 and February 2009.
The Reserve Bank of Australia (RBA) has also been quick to respond to the ebbing economic conditions by aggressively cutting the official cash rate by 400 bps, to 3.25%, since September 2008. Further easing in monetary policy aimed at stemming the recession is likely in both South Korea and Australia.
And Spenders of Last Resort
Governments across the world are also trying to play the role of big spenders because the coordinated rate cuts and dramatic steps to support financial markets have so far had little effect on reversing the tide. So, governments are resorting to large stimulus packages to kick-start a recovery.
In the U.S., federal government spending is likely to be the main impetus for economic growth in the short run. The stimulus package accounts for about 3% of GDP in each of 2009 and 2010, certainly a significant boost. We expect the budget deficit to climb to $1.8 trillion in fiscal 2009, about 12% of GDP, and drop only slightly in 2010.
China is also attempting to prop up domestic demand growth. The Chinese government announced a 4 trillion Chinese yuan stimulus package in November 2008. Much of it contains projects that are planned spending that the government is bringing forward. S&P's analysts believe China is likely to weather the downturn better than most others, in large part through its ambitious stimulus plans.
In Japan, unfortunately, government action aimed at addressing the nation's economic woes has been relatively ineffective. S&P analysts believe Japan's weak fiscal position and a stalemate in Parliament have led to a situation in which solutions are limited and come too late.
Other countries are following suit. As the growth slowdown in India intensified, the Indian government responded proactively with a number of fiscal measures. However, this response has been limited because of the political cycle, with elections coming soon, and the already weak state of its finances, including a large budget deficit and rising extra-budgetary allocations. The Korean government introduced an economic stimulus plan in November and another in January. They included tax cuts and multiyear investment in major infrastructure and environment projects to create jobs. Seoul took further initiatives to ease access to credit, but S&P's Asian economist believes the fiscal stimulus moves in Korea will not be enough to prevent recession in 2009.
The U.S. Dollar Gets a Lift
The dollar strengthened sharply this February over last year against most currencies on the typical flight to safety. That has continued over the past two months on global growth concerns and continuing declines in commodity markets. The dollar reached $1.24 against the euro in late October before edging back to $1.25 more recently. We expect the dollar to remain strong near term as investors keep flocking to the safety of U.S. Treasuries and away from the euro and weakness in the Continent.
The dollar will probably weaken beginning in 2010, on concerns about the huge government deficit created to fix the U.S. credit crisis and the still large current account deficit. A weaker dollar would help real growth in the U.S. next year by encouraging exports and slowing import demand. However, it could also dampen expansion in countries that now have trade surpluses with the U.S.
The Shakeup Looks Set to Continue
By now it's clear that the global economy is contracting in response to the U.S. recession. What started as America's subprime mortgage crisis has led to major upheavals in global financial markets and national economies. Lower oil prices and many countries' fast and coordinated actions will help relieve some of the sting. However, we believe the problems facing the world's economies in 2008 will likely continue through 2009.