The most widespread, longest and deepest recession since the Second World War
As is well known, this recession is global and has been accompanied by a financial crisis. It is the longest and deepest recession since the Second World War (see Chart 1). Only a few economies – China, India, non-oil-exporting Middle East Countries and Africa – will avoid a contraction in GDP in 2009. With its global scope and the accompanying financial crisis, the current recession has all the features to make it both longer and deeper than most past recessions. It will also take longer for economic activity to recover to pre-recession levels, as shown by a recent IMF study of 122 recession episodes, of which 15 were accompanied by a financial crisis. Recessions are considered as synchronised when at least 10 of the 21 advanced economies suffer from a recession simultaneously (Table 2). This recession is hitting both those countries which have a positive balance of payments and those which have a deficit. It is being driven by the elimination of global imbalances. The crisis in the sub-prime mortgage market and in securitisation was not just the result of failures in financial supervision and regulation; it was
Where are we now? Are we over the worst?
The performance of economic indicators in recent weeks has encouraged a degree of renewed optimism and the markets have been on the lookout for any sign of the oft-discussed green shoots of recovery. However, a number of fundamental factors lead us to believe that the recovery expected next year will, at best, produce a period of lacklustre growth.
Signs and sources of improvement, and their limits.
In the US, the ISM manufacturing index climbed to 40.1 in April (from 35.8 in February) whilst the non-manufacturing index hit 43.7 (from 41.6 in February, when the index started to reverse its decline – see Chart 5, p.8). The rate at which the market for new houses is shrinking slowed (-30.6% year-on-year from -44.6% two months earlier) and consumer confidence rallied to 39.2 (Conference Board Index) from 25.3 in February, thanks to an improvement in the expectations component. Even so, activity indicators continue to point to a contraction. In simple terms, the fall in GDP will be significantly smaller in the second quarter of 2009 than it was in the previous two quarters. Indicators for the euro zone paint a similar picture, with the manufacturing PMI at 36.8 (33.5 in February) and the non-manufacturing PMI at 43.8 (39.2 in February – see Chart 6, p.8). This slight improvement set a number of observers off on the hunt for good news and led to somewhat over-enthusiastic interpretations. For example, it was enough for the number of job losses in the US to fall from 699,000 in March to 539,000 in April for some to conclude that conditions in the labour market are improving – ignoring the fact that the unemployment rate had risen by 0.8 point, to 8.9%, in two months and that the job-loss figures for the previous months had been revised upwards. What is clear, however, is that some of the economic headwinds are easing. A large part of the collapse in GDP in the first quarter (down 6.1% on an annualised basis after a 6.3% fall in Q4 2008) was caused by a violent adjustment in inventories, which knocked 2.8 points off growth. Once excess inventories have been whittled away, one of the major factors driving the contraction of the economy will have been eliminated. Moreover, it only needs the rate of inventory reduction to slow for the contribution of inventories to economic growth to become positive. Deflation (the consumer price index was down 0.7% year-on-year in April) is boosting the purchasing power of individuals despite the slowdown in nominal income growth (wages increased by 4.1% in Q1 2009, after 5.2% and 5.7% respectively in the previous two quarters). Given the improvement in affordability following the collapse in prices (see Chart 7), the residential real estate sector is starting to show signs of stabilisation (see Chart 8). Housing starts have fallen to such a level that the effects of the increased solvency of consumers and demographic factors will combine to stop residential investment making a negative contribution to final demand. House sales are falling more slowly (down 30.6% in March compared to 45.5% in January) and stocks are shrinking (10.7 months of sales in March, from 12.5 months in January for new houses). Although interest rate cuts are unlikely to trigger a fresh wave of borrowing, they are reducing interest costs for borrowers on variable-rate loans. The narrowing of the mortgage spread following the Fed’s purchase of MBS provides an incentive for borrowers to refinance fixed-rate loans, which has the same effect as cuts in short-term interest rates. This process is also driven by the Treasury’s “Making Home Affordable” programme, introduced in February, which encourages the refinancing of standard mortgages (guaranteed or held by Fannie Mae and Freddie Mac), even for borrowers with negative equity, and encourages lenders to modify higher-risk loans (provided that debt service costs are not more than 38% of income). Lastly, although there is no need to stress this point, one also needs to take account of the effects of fiscal stimulus packages. Taken together, this group of factors, plus the recovery in the emerging markets of Asia under the influence of the stimulus measures taken by China, should allow a return to slightly positive growth next year. Several factors, however, suggest that a sustained period of strong growth is less likely. First, there is the action of lagging cyclical variables, notably employment and unemployment. Labour markets will continue to deteriorate for as long as growth remains below trend. However, given that it is unlikely that a new wave of borrowing will fuel demand, as consumers seek to consolidate their financial positions and face a continued negative wealth effect (real estate prices are falling, preventing any withdrawal of liquidity from real estate assets, whilst the recovery in share prices is still a considerable way off wiping out past falls), demand will remain entirely dependent on incomes in a labour market that will continue to languish in the doldrums. The negative output gap (see below) will continue to hold back investment, whilst the recession will increase another lagging cyclical variable, company failures. Lastly, setting aside issues of their effectiveness (strength of the multiplier in a situation where households are rebuilding savings with a view not only to improving their financial situation but also possibly in response to expectations of future tax increases), fiscal stimulus packages will start to drop out of the equation. To prevent this from happening, the stimulus packages would have to be increased on a regular basis, which looks highly unlikely. Thus, according to IMF estimates, US structural deficits corresponding to discretionary measures will rise to 1.4 points of GDP in 2007 to a peak of 4.8 points in 2008 and then ease to 4.6 points in 2009. In the eurozone, the structural deficit will rise from 1.6 points of GDP in 2007 to 3 points in 2009 and will remain at this level in 2010. Inflation and deflation Curiously the markets are worrying simultaneously about inflation and deflation. We focus first on deflationary factors. The scale of the recession is causing widening output gaps, which are setting new post-war records. Even with the recovery expected next year, growth will remain well below potential; the output gap is nearing 10% in the US, Europe and Japan, and unemployment rates will climb to over 10% on both sides of the Atlantic. Under these conditions, the Phillips curves describing the relation between the gap between observed unemployment and NAIRU (non accelerating inflation rate of unemployment) and underlying inflation suggest that there is a considerable risk of the latter moving into negative territory in 2010 (see Chart 15, p.15). Experience shows that recoveries, which naturally induce an acceleration in productivity gains, do not cause inflationary tensions. If we look at the last four American recessions (1973-1975, 1981-1982, 1990-1991 and 2001), goods inflation was running at an average of 4.8% at the end of the recession, 2.7% one year later and 1.9% two years later.
Concerning the United States
For the time being, it is the under-utilisation of resources that is the main determinant of price trends, particularly because this is a global phenomenon. It is all the more likely that underlying inflation will move first into negative territory, close to zero because its starting point is low (1.8% in recent months in the US, from 8% in 1980) and the sensitivity of underlying inflation to the output gap is high when the latter reaches extreme levels (see Chart 15, p.15). It is clear that after the task of getting the credit system working normally, the Fed’s main target is to prevent the highly likely technical deflation (a fall in the index) from turning into real deflation. Real deflation would result from a change in behaviour, with anticipations of falling prices becoming self-fulfilling prophecies: they would result in purchases being deferred, which would hit prices; the real weight of debt would increase, real interest rates would rise (nominal rates being blocked at zero) and this in turn would depress investment. The same would be true for real wages (nominal wages have a certain rigidity on the downside), resulting in falling employment and thence lower demand and prices. In other words we would enter a deflationary spiral. This is not, however, what we expect to happen, given the aggressive economic policies adopted and also because the emergence of deflationary expectations is being held back by the dispersion of price movements (Charts 9 and 10). This dispersion, measured as the standard deviation of movements in the index components, is 4.5 points. This is a level similar to that seen in 2003 when there were fears of deflation which proved after the event to be mistaken. If deflationary expectations are to take hold, it will require price falls across a very broad range of index components. The Fed has doubled the size of its balance sheet since September, and has introduced programmes which could possibly lead to it doubling again. This has resulted in some expressing concern that we see a return to inflation, with too much money chasing too few goods. We believe this is going a bit far. The scale of the output gap is such that it will take several years to close it. At the end of the recession in the early 1980s, it took five years of above-potential growth to do so. The CBO (Congressional Budget Office) does not expect the gap to be closed until the middle of the next decade, and this is based on assumptions tinged with excessive optimism (growth of 4% per from 2010, when a correction in balance sheets is likely to prevent a new wave of borrowing from bolstering consumer spending). For the time being, the explosion in the monetary base (up 89.2% year-on-year in February) has brought absolutely no excessive move in money supply, with M2 up by only 9.7% year-on-year. In other words the money multiplier has fallen and the ratio of M2/Base has dropped, in one year, from 9.1 to 5.3 under the influence of the preference for cash (see Chart 11). In fact, economic conditions are radically different from those in the 1970s, at the time of the last major inflationary wave. Then, even before the oil shock, the price-wage spiral was in full swing and productivity gains were evaporating. Average annual wage rises in the G7 countries ran at 10.9% between 1971 and 1973 and peaked at over 14% in 1974-1975; unit labour cost inflation rose from 7.5% to 13.8%. It is therefore hardly surprising that underlying inflation came close to total inflation (10.4% against 11.1% in 1974-1975), whereas real central bank policy rates fell into negative territory (-1.5%). Since then the economic landscape has been revolutionised by changes in labour markets, the introduction of inflation-targeting policies and the independence of central banks. Lastly, and most importantly, the Fed has a huge range of options if it needs to take a step back. It could suspend its programme of buying up ABS and MBS; it could merely hold the securities it has acquired to maturity without renewing them; or it could rapidly claw back the liquidity created through its TAF, CPFF and ABCP programmes, which all cover securities with a maximum maturity of 90 days. This last group represents one-third of the Fed’s balance sheet and two-thirds of the expansion seen since September 2008. The Fed could also issue its own debt and increase the remuneration of reserves. The question then is when is the Fed likely to return to conventional policy, i.e. raise its Fed Funds target? Taylor’s rule, assuming underlying inflation of 1.5% (in the middle of the Fed’s comfort zone), suggests that the ouput gap will require the Fed Funds rate to be raised in a ‘mere’ four years. However, we would not rule out some action well before this in response to a fall in unemployment, even though econometric estimates of “augmented” Taylor rules including GDP growth or the change in the rate of unemployment do not exhibit significant coefficients for these regressions, nor do they alter the coefficients associated to key variables (inflation and output gap).
And what about the eurozone?
In setting monetary policy, the ECB has used M3 money supply as a key benchmark. The reference growth rate of 4.5% per year has been unchanged since 1999. The underlying analysis on which this approach is based draws on the quantity theory of money: MV= PY or in dynamic terms: ln M(t)-ln M(t-1)= lnP(t)-lnP(t-1)+ ln Y(t)-ln Y(t-1) –ln V(t)-ln V(t-1) M is money supply, V the velocity of its circulation, P the level of prices, Y aggregate output. The choice of the reference growth rate for M3 growth of 4.5% is based on assumed trend GDP growth of 2.25%, inflation of 1.5% and a fall in the velocity of money of 0.75% per year. In fact, M3 growth has consistently run above the 4.5% reference rate. Between 1999 and 2008 it grew by an average of 7.8% per year. This represents a 36% excess in money supply compared to the level that would have been reached if the reference rate had been respected (see Chart 12).
This excess growth did not feed into excessive inflation, other than the temporary effects of oil price shocks. In reality one needs to take account of the impact on M3 of particular circumstances such as portfolio reallocations during flights to liquidity (after the tech-stock bubble burst for instance) which do not bring inflationary pressures. In particular, it is important to recognise that from the middle of the current decade, M3 growth has been driven largely by monetary transactions by non-banking financial agents (adding some 3 points to growth), which, as they do not increase demand, are also free of inflationary effects. What we have seen is a faster fall in the velocity of circulation of money than used by the ECB in drawing up the model that defines target M3 growth. Thus the ratio of nominal GDP to M3 fell from 1.18 in 2004 to 0.97 in 2008. The analysis of excess monetary creation on inflation draws on the P* model which links expected inflation to exogenous shocks (oil prices) and excess money supply. A recent study suggests that a 1% increase in excess money supply produces, over a period of 6 quarters, additional inflation of at most 0.2%. Given portfolio reallocations, the excess increase in money supply comes to 3% per year, generating additional inflation of at most half a point. Is the creation of money by the central bank potentially inflationary? Growth in the monetary base accelerated considerably in 2008, although this acceleration was not seen in either M1 or M3. As a result the ratios of M1/monetary base and M3/monetary base fell from 4.55 to 3.5 and from 10.3 to 7.9 respectively during 2008. The increase in the monetary base came from a change in the behaviour of banks, who lodged excess cash under the ECB’s deposit facility, which creates absolutely no inflationary pressures (see Chart 13). Indeed, the rising number of bankruptcies linked to the recession and the fall in asset values is holding back monetary creation by the banks. In such circumstances, and given the sharp drop in capacity utilisation (see Chart 14), it is clear that a period of slight deflation is a greater threat than a return to inflation.