2011: slowdown and fierce pressures

World growth slowed sharply last year to 3.8% from 4.9% in 2010. Fierce pressures shaped the economic environment. The tsunami in Japan disrupted supply chains in numerous countries, notably in the automobile industry. Political turmoil in the Middle East and North Africa drove up pressures on oil prices. Numerous uncertainties over economic prospects and policy rattled confidence in the United States while the European sovereign debt crisis festered and spread. The corrective measures that were taken repeatedly proved to be too little too late. The combination of implicating private bondholders in Greek debt restructuring, marking the sovereign debt instruments held by financial institutions to market value and tough recapitalisation requirements created an explosive cocktail that fuelled contagion.

The emerging economies held up very well with growth declining barely a point from the 7.3% reported in 2010, whereas growth in the advanced countries slowed to 1.6% from 3.1% in 2010. Despite this slowdown, which followed a strong rebound in 2010, several emerging countries reported remarkable performances. Growth is expected to reach 9.2% in China (vs. 10.4% in 2010), 7.3% in India (vs. 8.9%) and 2.8% in Brazil (vs. 7.5%). Through the first half, monetary policies in the emerging countries generally gave priority to fighting inflationary pressures. In China, inflation peaked at 6.5% in July before falling back to 4.2% in November. Similarly, inflation hit 9.4% in India in October, 7.3% in Brazil in September (before easing to 6.6% in November) and 9.5% in Turkey in November. Yet conducting monetary policy was no easy task since raising interest rates tended to attract capital, triggering unwanted currency appreciation. This led several central banks, including Brazil's, to take specific measures to halt surging exchange rates. With signs of a slowdown in the second half of the year, several central banks, including China's, began easing monetary policy (see chart 1).

In the United States, GDP growth was limited to 0.7% year-on-year in the first half. This poor performance, combined with the downward revision of 2010 growth estimates and an unemployment rate stuck at very high levels, planted doubts about the effectiveness of economic policy and raised fears of a double-dip recession. The Fed launched a second round of quantitative easing, or QE2, purchasing $600bn in Treasury securities between November and April and reinvesting maturing MBS in the same instruments. The aim was to bring a wealth effect into play and to stimulate demand for home loan refinancing. It did not prove to be very effective at a time when households were still trying to reduce debt. By stimulating the search for yields, quantitative easing also encouraged the withdrawal of capital and resulted in a welcome decline in the dollar. But it also helped drive up commodity prices, which fuelled inflation and eroded the purchasing power of household revenues. In early August, Standard & Poor's downgraded America's sovereign credit rating, largely due to the lack of visibility over the proposed budget as the executive branch and the two houses of Congress struggled to reach a compromise. This further eroded confidence, which was already hit by fears of a doubledip recession and possible contagion from Europe. Against this backdrop, third-quarter growth was more robust, with a rebound in both domestic and external end demand. Foreign trade ended up making a 0.5 point contribution to growth. The negative contribution of stocks, which slashed 1.6 points from growth, was good news for the fourth quarter. The rebound in economic indicators confirmed this trend, with the manufacturing ISM index rising from 50.8 to 52.7 in November and to 53.98 in December, with a new orders component at 55.3. Household confidence also picked up: the Conference Board index rose from 40.9 in October to 55.2 in November and 64.5 in December. Improvements could be seen in the assessment of both the current situation (which increased from 27.1 in October to 46.7 in December) and future expectations (from 50 to 76.4). These improvements largely reflect the decline in pessimism about job market conditions (the balance of responses between "jobs are abundant" and "jobs are hard to find" increased from -43.3 to -35.1 over the past three months).

Real estate prices continued to decline (the S&P's Case/Schiller index for the 20 biggest cities declined 3.4% year-on-year), but home sales picked up, albeit from very low levels (new home sales were up 10% year-on-year in November and existing home sales rose 10.9%).

Despite an inflation rate of 3.9% in September, the Fed pledged to hold the Fed funds target rate unchanged through mid 2013 and implemented a new round of non-conventional measures. Operation Twist consisted of purchasing bonds with maturities of 6 to 30 years, which were financed by selling bonds with shorter maturities. US long-term rates have fallen sharply since Operation Twist was launched in September. Money market funds helped this movement by reducing their exposure to European securities in favour of T-bills, holdings of which had been negligible before the crisis but accounted for 10% of assets under management last fall.

In the eurozone, activity was buoyant in the first part of the year with first quarter growth of 0.8%, but slowed thereafter to 0.2% in the second and third quarters. The composite PMI index dropped below 50 in September and has since held at levels signalling an economic contraction in late 2011 and early 2012 (see chart 2).

In spring 2011, the ECB raised its key refi rate to 1.5% in an effort to contain any risks of inflationary pressure or expectations. At the same time, it extended liquidity injections in unlimited amounts at fixed rate to counter pressures in the interbank market. In the second half of the year, the ECB launched the Securities Market Program to try to contain the effects of contagion, swelling its portfolio of government bonds purchased on the secondary market, with outstandings rising to more than €210bn.

With the return of disappointing growth prospects and mild inflation expectations since summer, the ECB cut its refi rate by 25bp on two occasions, bringing the key policy rate back to 1% in December. The ECB also launched a 12-month long-term refinancing operation (LTRO) in October and reactivated its programme of purchasing covered bonds, with a target of €40bn in a year (see chart 3).

In December, the central bank announced two 3-year refinancing operations, expanded the pool of paper eligible as collateral in its refinancing operations and cut the mandatory reserve rate from 2% to 1%. The first 3-year operation was conducted on 21 December, and resulted in a record injection of €489bn. The second will be held in February. The banks now have major reserves with the ECB (more than €450bn).

In Japan, GDP contracted slightly in 2011 (estimated at -0.3%) after a strong rebound in 2010 (4.1%). This rebound was not strong enough to erase the impact of the recession (-1.2% in 2008 and -6.3% in 2009), which was much more severe than the OECD average (-3.8% in 2009). This year's weak performance naturally reflects the impact of the disastrous tsunami last winter, which resulted in a 1% decline in H1 GDP. This supply chain shock also eliminated Japan's foreign trade surplus.

The second half of the year was marked by an unexpectedly robust and rapid turnaround. During the fall, manufacturing output returned to the levels that prevailed before the tsunami. Yet as of mid summer, there had been signs of a slowdown, notably in the economic surveys. The stimulus created by reconstruction spending was increasingly being offset by the slowdown in foreign demand, notably in the emerging countries of Asia and due to the strong yen (the effective exchange rate rose 6.5% for the year). Japan continued to be hit by persistent deflationary pressures, and the price index excluding energy declined 1 point year-on-year toward the end of the year.

Under this environment, the Bank of Japan maintained an accommodating monetary policy with interest rates at virtually zero and stepped up nonconventional measures. It increased its asset purchasing programme from JPY5 trillion to JPY15 trillion, and increased liquidity injections at fixed rate from JPY5 trillion to JPY35 trillion, to stimulate activity and to counter upward pressure on the yen.

Under the weight of three reconstruction spending programmes, public finances deteriorated again. The deficit swelled to 8.9 points of GDP (vs. 7.8% in 2010) and the debt ratio hit 212%, an OECD record. For the moment, deficit financing is facilitated by persistently low interest rates (10-year rates at about 1%). Yet as the IFM pointed out recently, there could be a reversal in market sentiment. Consolidating public finances is bound to become the top priority of economic policy again in the years ahead.