Hamish McRae: A downturn will come eventually, but later than most people think

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The Independent Online

Could I be wrong about the global downturn? You have to keep asking yourself that question these days because the flood of information about the slowing developed world economies has been pretty relentless and the financial markets are refusing to allow the savage cuts in United States interest rates – and presumably a small one in UK rates later today – to cheer them up.

My own view has for more than a year been that 2008 will not be the problem year for the world economy but the outlook for 2009 is more worrying. There will be a downturn, analogous to those of the early 1980s, early 1990s and early 2000s, and as far as the UK is concerned it is likely to be less serious than the 1990s one (because we have control of our own interest rates) but more serious than the 2000s (because our fiscal position is less favourable). But the downturn will come later than most people think, thanks both to the momentum in the world economy and to the demand from China, India and the other emerging economies.

Now, to give away the answer to my question above, I think that is still right, though with a twist that I will come to in a moment. But in fairness to readers I should present the evidence for the counter case, evidence that has been piling up in recent days.

Exhibit one comes from the US. We have just had some really wacky data from the Institute of Supply Management, which shows a sudden dramatic slump in activity in the US services sector. This is by far the largest chunk of the US economy and if the data is right, it does suggest that the economy may already be in recession. The data may be wrong or at least distorted because there have been changes in the way the numbers are put together, but it is disturbing nonetheless.

Exhibit two comes from Europe and this one is more solid. There has been a sudden deterioration there in the purchasing managers' index, which gives an early warning of economic activity and is now heading towards the level it was at in 2001 on the way down. Unlike the US, however, it is still above 50, the level signalling actual contraction.

Retail sales, particularly in Germany, have been very flat. Unlike Britons, if Germans have an increase in their pay packets they tend to save the difference rather than spending it. So huge reductions in the January sales have failed to do much for demand. Interest rate cuts? Not yet, because the European Central bank is hamstrung by high inflation and appears to feel, rightly or wrongly, that it cannot cut rates for a few months more.

Here the Bank of England will have fewer inhibitions. We start from a higher base and have inflation, on the CPI measure though not on the RPI, at a more acceptable level. Our consumers are more indebted too and more sensitive to the swings in the housing market. The bottom two graphs show house price trends and retail sales, with some projections from the Bank Credit Analyst on future movements of both.

As you can see, BCA projects house prices going negative by the middle of the year and retail sales growth slowing to less than 1 per cent a year within the next 12 months. If that proves right, it would be the slowest growth since the middle 1990s.

So let's stand back and calibrate all this stuff. Whether or not the US data proves accurate it is certainly disturbing in the sense that it will disturb the Federal Reserve. There will be more US interest rate cuts if the weak data continues to pile up. So the question then is whether interest rates well below inflation will stimulate demand. They must have some effect but there is the "pushing on a string" phenomenon, where even cheap money does not entice people to borrow more. That is rational: in Japan in the early 1990s near-zero interest rates failed to boost demand, for people worried about losing their jobs did not want to borrow, large firms were flush with cash and did not need to, and property companies found that values were falling so fast that there was no incentive to develop more buildings. The efforts to boost the economy by running a large fiscal deficit did not help much either.

The US is not in the same sort of trap as Japan was then but there is one uncomfortable parallel. The US banking system is pretty shell-shocked by its pile of bad debts and has similar structural problems with bank balance sheets. If the property markets, both residential and commercial, continue to deteriorate even very cheap money could fail to result in a swift bounce-back. So whatever happens in 2008, 2009 might not see the quick recovery that many expect.

Europe? I have been surprised by this latest weak data because I had expected things to soften more slowly. It may just be that the European business community became over-optimistic last autumn and now it is reacting to that. It may be that the strong euro is doing more damage than we all expected. The most disturbing problem is that different chunks of the eurozone need different interest rates, with Spain and Ireland both suffering from falling property prices and Italy and Germany from soft domestic demand. Quite how the ECB resolves all this I really do no know.

As for the UK, well the current indications are that the economy is still growing and companies are still hiring but that may be because we/they have not yet adjusted to what is in store. Things don't feel that soft, at least outside the housing and retail sectors and the more competitive sterling will help drive export orders. I may have missed it but I do not recall seeing a single forecast that there will be a UK recession this year. Most of the forecasts are now in the 1.5-1.8 per cent growth range, which is a long, long way from recession. So taking the developed world as a whole, despite this new discouraging data and allowing for further financial ructions, the message may be for a more rapid slowdown than seemed likely a month ago, but not so rapid as to make all the projections look ridiculous. And that is just the developed world. Remember that China will add more overall demand to the world this year than either the US or Europe and that India will add more than the UK or Germany. So I do think my view that 2008 is not the problem year basically should stand – but with a wrinkle.

That wrinkle is that this may turn out to be a year of two halves. The first half will see OK growth in most of the developed world, though maybe not the US, but the second half will be more worrying. Here we will scramble on fine till the autumn but during the final months of the year we will find things slackening more markedly. So the overall growth number for the UK in 2008 will not be too bad but the growth will be front-end-loaded. And 2009 will indeed remain the problem year.

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