It has been a pretty rough holiday season, hasn't it? Things may have calmed down a bit now but I think we have to accept that we are probably still in for weeks, maybe months, of bumpy markets. And I think there will be casualties among the financial institutions. The classic signal of a turning point in similar periods of financial stress has been a large bank somewhere in the world needing to be bailed out by the authorities; that is perfectly possible this time too.
That said, enough calm has returned to put what has happened into perspective – or at least to identify the big issues that the storm has raised. The most fundamental of these is the extent to which events in the financial markets will feed through into the world econ-omy, and that is probably the best place to start.
So far not much has happened, but you would expect that to be the case. The lags are both long and uncertain: it takes between three months and two years before a financial event feeds through into an economic outcome; we have had less than a month. So far, the US economy seems to be continuing to grow steadily; there were some strong figures for durable goods orders on Friday. The housing market has tanked (of which more in a moment) and there is talk of a sharp slowdown, but so far that is not evident.
Here? Well, strong growth was certainly continuing through the first half of the year, with second- quarter growth confirmed at 3 per cent annual rate in the revised GDP numbers, also released on Friday. The shock figure was inflation: the GDP deflator, the best overall measure of inflation throughout the economy, was 3.8 per cent. That is the highest since 1996. The consumer price index has subsequently fallen but the Bank of England will be unable to relax until this broader measure comes back to an acceptable level.
Elsewhere, growth is also positive. The eurozone economy is the strongest it has been for about six years; China races on, of course; and the rest of the world in aggregate is growing faster than it has ever done before.
So these financial shocks are hitting a remarkably robust global economy – one that needed to be slowed by higher interest rates. So it would be plausible to argue that the bumpy financial markets will reduce the need for higher rates, insofar as the bumps slow growth. Will they do so?
The answer has to be yes to some extent, but only to some extent. Credit Suisse has done some simulations that suggest a 10 per cent fall in share prices depresses investment by around 3 per cent and consumption by 0.3 per cent after five months. But then things start to recover and after a year the impact is very small indeed. So you might conclude that things would have to get a lot worse before there would be a real dent to global growth and consequently a really strong downward pressure on interest rates. If there were a global financial meltdown then things would be different, but we are not in that position.
There are, however, obvious risks. One centres on US house prices, which, through the sub-prime mortgages, were the indirect trigger for recent events. American Express Bank thinks that the US housing market faces a "perfect storm", with falling demand meeting rising supply. It expects prices to fall significantly further. Unlike in the UK and Australia there has been plenty of new building, so the market will not follow their pattern, both of which saw an easing and then a recovery. That may turn out to be right, though there are signs that bargain-hunters are moving back into some markets. What is surely beyond dispute is that the global boom in residential property is over and the issue now is whether prices broadly plateau or whether there will be a decline in some markets.
It is also beyond dispute that the world's central banks will be very cautious about creating another asset bubble. Whether rates have to be cut will depend on individual markets. In the case of the UK, I still expect the next move will be up, not down, but that may be delayed to the end of the year. The big point is there will be a period of fairly expensive money, probably through most of next year.
Other consequences will include a tightening of financial institution regulations. ING bank suggests that there may be overkill and the costs of bank funding will rise as a result. Obviously, US mortgage standards will be tightened, but ING thinks also that regulation will spread to hedge funds. Paradoxically, there may be more volatile markets as a result, because hedge funds will be less able to take positions against the market flow.
Similar points are made by the UBS economics team, which thinks there will be knock-on effects for UK mortgage lenders: they too will be under pressure to improve credit standards. It also notes that if US households start to rebuild their savings, as sooner or later they will have to, that will also have knock-on effects in the rest of the world.
Another point is made by Credit Suisse, which is that US and UK share markets move closely together. So if the former does badly, there is likely to be contagion here.
Perhaps most important of all, central banks will behave differently in future. My feeling is that they will pay more attention to the broad objective of fostering stability and less to the narrow one of holding inflation between specific targets. Here in the UK, the Bank of England has been pretty successful at keeping inflation within the specified boundaries. But it has been less successful in curbing wider inflationary pressures and completely unsuccessful at preserving reasonable stability in housing.
We have learnt this month that markets are extraordinarily global: when America sneezes, it is not just Europe that catches a cold. But economic power is gradually shifting towards Asia and that leads to another question: what would happen were China to sneeze? I shall be reporting from Shanghai next week and that is one of the matters I shall try and look into.Reuse content