The recovery in the major economies is slowing, but fears of an inevitable and quick return to contraction are groundless if policymakers keep their heads.
Double dip recession fears are misplaced
Once again, the collective wisdom of the global stock market has pre-empted official economic readings. After a breathtaking rally that lasted just about a year, the global equity markets peaked in mid April. Yet only last week we received formal confirmation that GDP in the US had slowed substantially. The big question now is whether we face a double-dip recession. The good news is that even with important leading indicators auguring further slowing of the major economies, it is unlikely we will encounter the rare event of a double dip, unless policymakers err. The bad news is that in the unlikely event of double trouble, we will have little left in the line of traditional instruments to fight it.
First, by way of definition, a double dip should be defined as two recessions following each other within a very short period. A softening of growth during the recovery phase is not a double dip. The business cycle does not develop in completely straight lines. Recoveries see changes of pace, as do downturns. The cycle-dating committee of the national bureau of economic research, a private organisation based in Massachusetts, has not yet formally called an end to the US recession that started in December 2007. Presumably, at some point in the next couple of months, the committee will announce the recession ended some time last year.
On the traditional definition of two consecutive quarters of negative growth, the US recession ended in the third quarter last year, as did the recession in the euro zone. A new recession within two years or so would certainly have to be considered the second recession of a double-dip trajectory. While many people talk about double dips, these do not occur often. In the US, the only post-Second World War double-dip recession occurred in 1980-1982. Germany experienced a double dip in 1993-1995, and Japan in 1997.
So what has caused recent weakness in economic data? Coinciding factors have contributed to a weakening of the global recovery. First, in a number of countries, fiscal policy has become restrictive. This is the case in China and to some extent in a number of European countries. Even where policy has not yet become restrictive, the positive effects of earlier stimulus measures are fading. Second, while companies will continue for some time to rebuild inventories, the biggest impact in terms of economic growth is probably already behind us. Third, the expiration of the generous tax credit for US first-time homebuyers at the end of April is leading to renewed weakness in housing.
In 1980-1982, monetary policy certainly played a big role in causing consecutive recessions in the US and elsewhere. The Fed raised its federal funds rate to 20 per cent in early 1980, which was sufficient to trigger the first recession. The Fed then eased spectacularly, bringing the rate down to 9.5 per cent by July 1980. This easing surely helped to start a recovery. But no sooner had the recession ended than the Fed raised rates again, to 18 per cent by the end of the year, presumably contributing to the second dip into recession that started in July 1981 and lasted until November 1982.
Such a spectacular course of monetary policy is not going to be reproduced this time. Those fearing a double dip cite US housing, restrictive Chinese policies and European fiscal consolidation as the most likely triggers. The double dips in Germany and Japan were also "man-made". In both cases, fiscal tightening pushed the economy into its second dip. Commentators therefore generally argue that double dips are caused by policy mistakes.
Will China, now officially labelled as the world's second-largest economy, experience a hard landing? Such fears seem unwarranted. Chinese policymakers provided tremendous support to economic activity during the global downturn starting in 2008. Economic growth indeed accelerated, and lending, money growth and house price inflation increased. Subsequently, policymakers have changed direction. They have taken very specific measures to ease lending growth and to slow the housing market.
The policymakers seem to be successful: the economy is slowing, but at a pace that the authorities probably desired. Inflation has picked up this year. But there is no reason to panic on that front. Headline inflation fell back in June to 2.9 per cent while non-food inflation was stable at 1.6 per cent, not exactly levels to trigger overly aggressive further tightening. Will fiscal consolidation trigger a double dip in Europe? Much more so than in the US, European governments have already started the process of fiscal consolidation. This will certainly have an impact on economic activity in the short term. We estimate that fiscal policy will be contractionary next year to the tune of about 1 per cent of GDP. This is not sufficient to trigger a new recession. It is therefore too negative to argue that policymakers are in the process of making a policy mistake that will cause a second dip. In addition, the fall of the euro is an important compensating factor. As a very rough rule of thumb, a 10 per cent decline in the trade-weighted euro should contribute 1 per cent to GDP growth.
What are leading indicators saying? The manufacturing index of the institute of supply management (ISM) has been a fairly good indicator for signalling a recession. The ISM index has to fall to about 40-45 to reliably signal an approaching recession. While the index has fallen in recent months, at 56.2 in June, it is also a long way from recession territory. After the recessions of 1990-1991 and 2001, the ISM index weakened after its initial rise. In both instances, the index fell to just above 45. In both cases, the recovery was weak, but in neither case did a double dip occur.
The most striking piece of economic data in recent days was the strengthening of business confidence in Europe last month. The purchasing managers indexes for the euro zone improved, particularly thanks to the spectacular improvement of German business confidence. This was also reflected in the Ifo Institute's business climate index, which rose from 101.8 in June to 106.2 last month, the highest level since July 2007. Another important indicator is corporate profits. Currently, the profit cycle is still gaining altitude. The reporting season for second-quarter company results has so far exceeded expectations in earnings and sales. We expect strong earnings to continue in the near term. The earnings cycle therefore certainly does not signal an early recession.
Economic circumstances are highly unusual, making forecasting even more difficult than normal. A continuation of the recovery, albeit perhaps at a more modest pace, seems to be the most likely scenario. Should this cautious optimism turn out to be misplaced and should the economies of the US and the euro zone fall into recession before too long, the policymakers will have very little left of their traditional arsenal to fight the recession.
They would have to resort to stepping up their use of non-traditional measures, in particular quantitative easing, similar to that undertaken in late 2008. While it is unclear whether such policy measures will make a meaningful difference to generating and sustaining economic growth, earnings and employment, it is clear that such policies will drive up the already high sovereign debt overhang and make the long-term bond market less attractive.
Rehan Syed is the head of portfolio management at the ABN AMRO Private Bank in Dubai. The opinions expressed are personal and are not necessarily those of his employer.