The International Monetary Fund this week downgraded its economic growth forecasts for the world for this year and next year. The actual decline was not by much, but the message is clear: The global economic recovery from the Great Recession of 2008-09 has faltered.
Some economists think the IMF’s forecasts of 3.5% global growth this year and 3.9% next year are too optimistic. But the IMF based its forecasts on an assumption that policymakers in both developed and emerging markets will take action to ease the global pain.
The key question is: What action can policymakers take? During the Great Recession and its immediate aftermath, central banks in the US and other developed economies slashed their interest rates to record lows and governments spent and cut taxes to stimulate economies.
Interest rates were cut to zero in the US and the UK – where they still remain – and governments in 2008 set aside concerns about deficits and public debt to spend their way out of recession. When interest rate cuts didn’t do the job, the central banks in the US and UK turned to more controversial measures – “quantitative easing” (QE), which is effectively the printing of money.
The US Federal Reserve (Fed) undertook 2 rounds of QE – QE1 amounted to $1.75trn from 2008-2010 and QE2 saw a further $600bn pumped into the banking system. The way in which the Fed pumped the money into the system was by buying long-term bonds, which had the effect of lowering long-term interest rates. This has a ripple effect down to the rates that consumers pay.
The Fed is currently still acting to keep long-term interest rates low, particularly mortgage rates, through its “Operation Twist” – buying long bonds and, at the same time, selling short dated paper. The net effect is that zero additional cash is pumped into the market, as the cash that goes in when long bonds are bought is taken out when short-term paper is sold.
But the question now at the forefront of market players’ minds is whether the Fed will launch QE3 – another round of “printing money” or pumping cash into the market. Fed chairman Ben Bernanke disappointed the markets this week on this topic when he testified before the Senate Banking Committee. He painted a bleak picture of the US economy and said the Fed was watching closely to see if the recent slowdown was “enduring”.
While this gloomy picture gave hope to those expecting QE3, Bernanke himself didn’t make any promises, which left the markets with the dreaded conclusion of “mixed signals” from the Fed. This uncertainty didn’t take the issue further than last week’s release of the minutes of the last Federal Open Market Committee meeting, which suggested that coming economic data would be crucial for the decision on QE3. As far as the data are concerned, the US retail sales figures released this week were proof of a very weak economy, with economists downgrading their US economic growth forecasts.
The European Central Bank (ECB), the Bank of England and the Chinese central bank all eased monetary policy recently, with the ECB taking its benchmark lending rate to a record low of 0.75%. The ECB, ever the inflation hawk, has been the odd one out among the zero interest rate central banks but may find itself forced to take rates even lower. Its rate cut was seen as “too little, too late” by the markets, which had expected more aggressive action, such as pumping money into the banking system.
The onus for the world economy now lies on monetary policy, as the limits have been reached on fiscal policy. In most of the developed world, there’s deep concern about government debt and efforts are going into reducing deficits. This means spending cuts and tax increases. If implemented too fast, these will harm efforts to get global growth going.
Care must be taken that fiscal policy is not too restrictive – that it doesn’t actually harm growth, as has been the case in the eurozone, where severe austerity has prolonged recessions in some countries.
In the US, politicians’ inability to agree on how to tackle the fiscal problem might force the country into excessive government spending cuts and punitive tax increases. These measures are scheduled to take effect automatically from the start of next year, and are the result of the inability of the Republicans and Democrats to reach agreement on deficit reduction in the US. This looming crisis has been dubbed the “fiscal cliff”. The IMF has urged US politicians to resolve the “fiscal cliff”, as has Bernanke, who is the person who coined the phrase.
Expectations are that the “fiscal cliff” will be resolved after the US presidential election in November, when the two parties can afford to compromise without losing face at election time. But until then, fears that the US economy will go over the cliff will affect consumer and business confidence in the world’s biggest economy.
The global recovery is faltering, and action is needed from policymakers.