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Economics Weekly

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High global inflation has hit economic growth

Tue, Sep 2 2008, 06:30 GMT
by Trevor Williams

Lloyds TSB Financial Markets

With second quarter gdp data now available for the main economies, this might be a good time to look at how global economic growth has performed so far in 2008. Chart a shows that Q2 growth is currently much lower than in the year earlier in all of the major economies. Of course, the world economy has been hit by two major shocks in the last 12 months, the bursting of the credit bubble and a big rise in global inflation. Although the two effects are difficult to separate - both are at work to reduce the pace of economic activity - the sharp rise in price inflation appears to have more obviously hit household incomes, raised firms’ costs and led to weaker growth. Tighter lending conditions have intensified the slowdown. As a result of this, consensus forecasts for economic growth have been lowered sharply for this year and next, see charts b and c, mirroring the rise in forecasts of price inflation.

Economic growth has been revised lower…
We have been continually revising our forecasts for the global economy to reflect the worsening trend of recent economic data. Indeed, a scenario we carried out in May suggested that the biggest risk facing the world economy was higher than expected inflation, partly driven by rising oil and food prices resulting from fast growth in the emerging markets and loose monetary policy in the developed countries in the last five years. Unfortunately, events have moved closer to this more negative scenario for economic growth than in our central forecast at the time. However, it is still likely that the world economy will avoid recession, with the US showing tentative signs of also avoiding recession, but growth in the UK, Japan and the eurozone continues to weaken more than expected earlier in the year.

…as price inflation has proved sharply higher than expected...
Despite all the worries about the bursting of the credit bubble, and the initial assumption that this would lead to lower inflation as growth weakened - as individuals and companies were prevented from borrowing as much as they would like and so cut spending - it is ironic that it is, in fact, accelerating price inflation that has negatively impacted the real economy most severely in the last few months. It may be that the economic effects of the credit crisis are slow burning though the impact on banks and financial markets are plain to see. After all, the reduction in credit availability must be acting to weaken economic growth more than otherwise, but it is not enough to prevent price inflation from rising, at least in the short term, while the upward pressure from higher oil and food prices is so great. More worrying is the fact that core price inflation, which excludes the effects of energy prices and food, is also rising even as economic growth weakens.

Forecasts have been revised lower for 2009 as well…
Since the start of 2008, consensus forecasts of gdp growth have been revised lower around the world and forecasts of inflation have been revised higher. As shown in charts b and c, the upward revisions to inflation applies to all the major economies as are the downward revisions to growth. And the same profile is repeated in 2009, with consensus growth for the US, UK and the euro area expected to be weaker than in 2008, though price inflation is expected to be lower in each case. Our forecasts, in table 1, also show that global growth is weaker in 2009 than this year, as higher global interest rates in 2008 to counter high inflation weaken the pace of economic activity with a lag. However, global growth is projected to bounce back to just above 4% in 2010, when most of the major economic areas see a recovery back to trend growth. For the UK, our growth forecast for 2008, at 1.4% is in line with the consensus, but our projection for 2009 is higher at 1.7% versus the 0.9% consensus. Despite this difference, what is clear is that UK economic growth in 2009 is likely to be well below the average rate of the last 10 years of 2.9%.

...but there is still a lot of uncertainty about forecasts for the year ahead
For the UK, and possibly the US, a sharp fall in the trade weighted index this year could boost manufacturing output in 2009 by enough to prevent growth from being below this year’s pace. Table 1 shows that economic growth in the emerging markets, though weakening in 2009, is still some 2 to 4 times faster than in the developed economies. The example of the US and UK in charts d and e illustrate quite clearly how inflation can hit growth. Higher price inflation reduces real wages (nominal wage inflation minus the rate of price inflation), unless wage inflation responds, though this can lead to an even more destructive cycle of a wage price spiral as one chases the other up. If wages do not respond, as seems to be the case so far, especially with growth so weak, lower real wages will lead to weaker disposable income growth and so to a reduction in consumer spending growth. As price inflation falls back in 2009, see table 1, some rise in real wages is likely and, as the relationship in charts d and e implies, some rebound in economic growth, is therefore likely. However, in our opinion, the peak in price inflation has not yet been reached and so the effects on growth are not certain. Although consensus forecasts have taken account of the likely inflation rise yet to come, one thing that is certain is that there are likely to be more revisions to economic growth and inflation projections in the year ahead. Moreover, history shows that the consensus view is rarely the most accurate.

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Published on  Tue, Sep 2 2008, 06:43 GMT