This has been a week for seismologists, nuclear scientists and military strategists, rather than for economists. (And they call economics the dismal science!) Today, my regular weekly summary will focus on a few of the items that you may have missed amid the dramatic events in Japan and North Africa. While the world economy is still growing rapidly, the peak rate of growth may have been reached, and core inflation is edging higher. We have seen the first significant sell-off in risk assets since QE2 was announced last August. A correction, or the top of the bull market? That will depend on oil prices.
1. Global growth is still in good shape…..
Last week’s data continue to point to very strong global activity. As the first graph shows, the New York and Philly Fed surveys for March are indicating another robust month for the US ISM survey.
It could rise by two points when it is published on 1 April, taking it into stratospheric territory. However, the “bean counts” of official economic data are generally not as strong as the growth rate implied from business surveys. For example, official data in the US point to growth of only around 3 per cent so far in Q1, more than a full point below the rate implied by the business surveys. Higher oil prices may be beginning to bite.
2. But growth rates may be peaking for now …
Apart from the impact of oil prices, we also need to be mindful of the continuing slowdown in China, and the (hopefully limited) damage which the Japanese earthquake may do to near term Asian growth. Meanwhile, in the EU, fiscal tightening is underway, and the ECB will probably raise interest rates in the next couple of months. This is now having an impact on the euro, which is in turn depressing the German stock market.
For global equities, the best moment in the economic cycle is when three criteria are met simultaneously. First, the level of output needs to be below normal capacity, so there is room to expand without causing inflation to rise. Second, output growth needs to be above its trend rate, so the margin of spare capacity is declining. (This tends to be the best phase of the cycle for profit margins.) And third, the rate of growth needs to be increasing, rather than declining.
In recent months, all of these criteria have been fulfilled simultaneously, and equities have behaved accordingly. However, there are some signs that the rate of GDP growth, while still high, may no longer be increasing. After all, it can hardly go much higher. The monthly change in the OECD global leading indicator dropped slightly in January, and the Goldman Sachs equivalent has now slowed in both February and March. So two of the three key cyclical criteria are still in place, which is usually enough to keep risk assets performing well on trend. But the third criterion is looking shakier. We may therefore have moved out of the sweetest of cyclical sweet spots for equities. That need not signal a major bear market – a larger drop in global growth rates may be needed for that to happen.
3. US core inflation edging higher…
One of the cornerstones of any optimistic view for risk assets is that the Fed will remain accommodative – especially now that both the ECB and the Bank of China are tightening policy. 
The case for believing that the Fed will not raise interest rates for a long while is made in this earlier blog. However, this week’s US CPI figures once again suggested that core inflation may have moved past its low point, mainly because housing costs have now stopped falling. The core CPI index rose by 0.2 per cent last month, and has risen at an annualised rate of 1.8 per cent in the latest quarter. Admittedly, this series tends to be volatile over short periods, but it now needs to be watched.
4. Markets show nerves as multiple shocks hit….
Has the world economy ever been hit by such a complex series of exogenous shocks at one time?
This week, global equities showed signs of sagging under the pressure, and are now slightly down on a year-to-date basis. For the same reason, bonds have perked up, and markets have become less concerned about imminent interest rate increases, even in the eurozone. However, unless growth prospects in the global economy fall more significantly than they have so far, this will probably be a market correction, not the end of the bull run for equities. By far the most important determinant of global growth will be the outlook for commodity prices. Last week, oil prices remained high as political uncertainty in the Middle East refused to go away. But food prices seem to lost some of their earlier upward momentum, which is good news, especially for emerging economies. As usual, oil prices will be the swing factor in the end.
5. Obscure Princeton professor comments on Japan…
Finally, my thanks to Joseph Belbruno, a reader, for drawing attention to this article on Japan written by the then little-known Ben Bernanke in 1999. With the economy mired in a liquidity trap, Mr Bernanke wrote the following:
I agree with the conventional wisdom that attributes much of Japan’s current dilemma to exceptionally poor monetary policy making over the past 15 years…The important question, of course, is whether a determined Bank of Japan would be able to depreciate the yen. I am not aware of any previous historical episode in which a central bank has been unable to devalue its own currency…In short, there is a strong presumption that vigorous intervention by the BoJ, together with appropriate announcements to influence market expectations, could drive down the value of the yen significantly.
Twelve years later, we may be about to find out whether Mr Bernanke was right.
