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Global Scenarios: Trends and risks

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Stagflation light

Wed, Jul 2 2008, 10:14 GMT
by Danske Research Team

Danske Bank A/S

• Central banks in uncharted territory

• - global inflation 'too high' amid slowing growth

• - while the Fed will do little but tough talk

• - but is facing a period of sluggish growth with a fiscal boost

• - with rising risk of contraction

Contents

• Introduction: Stagflation light
  
• US: Sluggish growth, with a fiscal boost
  
• Euroland:  Rate hike despite softening growth

Introduction: Stagflation light

• In the space of just a few months, fears of a global financial meltdown have been overtaken by a serious inflation scare. While the financial crisis is still ongoing, market conditions have improved sufficiently for attention to turn to the increasing rate of inflation, which is being driven up by still-rising commodity prices in the middle of a deteriorating economic outlook. This has fostered a ‘stagflation light’ environment, which over the past few months has prompted one of the most dramatic re-pricings of bond markets for decades.

• Developed economies remain seized due to tighter credit, slowing housing markets and a significant erosion of purchasing power stemming from higher commodity price inflation. While these economies performed better than feared in the beginning of the year, the near-term prospects have deteriorated somewhat further. The outlook for the coming quarters remains sluggish – but not disastrous.

• The US will probably avoid a recession, as the tax rebates will lift growth during the summer. However, the economy remains fragile, and growth will soften again later in the year as the fiscal stimulus fades. In 2009, the economy will gradually recover on the back of the lagged impetus from monetary policy, a stabilisation of the housing market and a boost to real income growth from lower inflation.

• The Euro area faces a hard time, with a stronger currency and further ECB tightening coming on top of the global headwinds. Importantly, signs of weakness in the German economy are now appearing. Hence, Euro area growth is set to slow below trend during H2 and into 2009 with rising risks of contraction.

• Emerging Markets (EM) have been hit harder by the high commodity prices than by the financial crisis. Rising inflation is eroding real incomes while simultaneously forcing central banks to tighten monetary policy. Hence downside risks to growth in EM are increasing.

• The surge in commodity prices has boosted global headline inflation, and this has been the decisive factor behind the change in mood among central banks. With global growth slowing moderately, supply and demand in the oil market should be more balanced going forward. Hence, a more stable oil price is expected to gradually bring down inflation over the next 12 months.

• Rising risks to inflation expectations have alerted – but to different degrees – central bankers. The ECB remains determined to fight inflation, with a hike on the cards for July, while the Fed is expected to do little but talk tough with an inflation-fighting bias. After July both central banks will remain on hold until the middle of next year. We do not expect a normalisation of US monetary policy to begin until mid-2009.

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Published on  Wed, Jul 2 2008, 10:22 GMT