The economic data are ambiguous, inflation could rise again and a steepening yield curve could derail growth.
The last few days alone have witnessed two major senior-level meetings to review the state and the fate of global economy. The G-8 finance ministers met on June 12 and 13; this was followed, last week, by a Summit meeting of the BRIC nations (Brazil, Russia, India and China). While the latter emphasised the need to look for an alternative to the US dollar as the global reserve currency, it did not come out with any specific ideas. As for the G-8, it noted with satisfaction “the recovery of stock markets, a decline in interest rate spreads” and “improved business and consumer confidence”. Stock markets in the rich countries have recovered since their lows of March, but are just about back to the levels that prevailed at the end of 2008.
Stock markets are supposed to be a leading indicator of the economy. The question is: Does the recovery of share prices suggest that the worst is over as far as the global economy is concerned? (To be sure, the market’s reputation as a leading indicator has been dented by its inability to predict the credit crisis and the global recession which followed.) However, the interest spread between the three-month London Interbank Offered Rate (LIBOR) and the three-month Overnight Indexed Swap (OIS) rate has narrowed significantly, suggesting some restoration of the confidence in the inter-bank market. Spreads for developing countries, even on short-term credit, however, continue to be much higher than normal.
It is a fact that the global economy is not shrinking as fast as it was until a few months back. This is also reflected in the prices of crude oil (these have crossed $70 a barrel) and in those of base metals like copper, lead, and zinc. The Baltic Index of shipping freight is at a seven-month high. The US housing starts are suggesting a demand pick-up, after registering a five-year low in April. But global trade volumes continue to shrink and export-dependent economies, particularly Japan and Germany, continue to suffer badly. The Japanese economy is expected to shrink 3.3 per cent in the current fiscal year (after a drop of 3.1 per cent in 2008-09); Europe’s output may drop by 4 per cent in the current year, the worst post-war contraction in economic activity. US GDP contracted by 6.1 per cent in the first quarter and unemployment is still rising, though at a slower speed. Overall, the signs are mixed and, as is usual for market analysts and economists, one often tends to over-emphasise data supporting one’s bias and under-emphasise the contrary news. To quote two examples cited by V Anantha Nageswaran in an article in Mint (June 16): Should one focus more on factory orders being higher, than on the downward revision to previous figures? Or, place more reliance on the jump in retail sales in the US in May, ignoring, the fact that much of the improvement came because of higher petrol prices? A cautious analyst would probably prefer to keep his/her fingers crossed about when the global recession would end.
The big issue thereafter is going to be “the need to prepare appropriate strategies for unwinding the extraordinary policy measures taken to respond to the crisis” (to quote from the statement of the G-8 finance ministers, June 13, 2009). This issue is already generating political heat within the G-8. Even before the finance ministers’ meeting, Angela Merkel, the German Chancellor, in an extraordinary public statement criticised the US, the UK and European central bank: “I am very sceptical about the extent of the Fed’s powers and the way the Bank of England has carved its own little line in Europe”; these policies “must be reversed”. She also criticised the European Central Bank for, “bowing to international pressure” in its purchase of mortgage securities in the market. It is extremely unusual for the head of a state to voice such direct critcism of central banks. One reason could well be that, since the hyperinflation of the 1920s, the German psyche is extremely sensitive to the possibility of inflation.
But there are increasing worries that given the extent to which both the monetary and fiscal taps have been loosened, a resurgence of inflation could well follow economic recovery, whenever it begins. Policy-makers have a very delicate tightrope balancing act ahead of them. As it is, the yield curve has steepened very sharply in the dollar-bond market. If it continues to steepen, thanks to the huge supply of treasury securities expected, this has the potential to derail economic recovery. Fiscal stimulus, howsoever needed in the short run, could well be counter-productive in the medium-term if it leads to a hardening of interest rates.
Tailpiece: I had raised a question about the justification for pouring public money to recapitalise Air India last week , and why it needs to be in the public sector at all. I got the answer in last Monday’s Hindustan Times: Air India needs to be a PSU to facilitate the issue of free companion tickets for the netas and babus traveling abroad on official business. And, what better reason can there be?