Monthly Archives: August 2011

Christine Lagarde

Christine Lagarde at Jackson Hole. Image by AP.

Read Gavyn’s response to readers’ comments on this post

Following the Jackson Hole symposium, market attention will be focused on the speeches by Ben Bernanke, Jean-Claude Trichet and Christine Lagarde. Golf used to have its “big three” – Nicklaus, Palmer and Player – and these three officials are clearly the equivalent among economic officials in the world today. With the developed economies apparently still failing to recover from the Great Recession, did they offer a co-ordinated blueprint for action? Not really.

The Bernanke speech disappointed some observers by failing to make the case for further near term easing by the Fed. That seems unfair. The FOMC announced a significant policy shift only three weeks ago, when it provided a forward commitment to keep short rates at exceptionally low levels for the next two years. That was enough to split the committee, and the Fed chairman has extended the next FOMC meeting on September 20th and 21st to allow full discussion of all the options. He clearly felt unable to offer any unambiguous signals before that important meeting. 

The key focus of the coming week in financial markets will be the speech of Fed chairman Ben Bernanke at the Jackson Hole conference on Friday. Last year, the same speech was taken as confirmation that the Fed intended to embark on QE2, and this eventually triggered a 30 per cent rise in risk assets over the next six months. With the economy still weakening, the Fed is once again in easing mode, and some in the markets are hoping for another full dose of QE. They are likely to get something rather different. 

Update: Read Gavyn’s response to your comments.

As recently as six months ago, mainstream economic forecasters were expecting real GDP growth to be comfortably above trend in 2011, and surveys of business activity were hitting new peaks. Of course, everyone knew that the underlying condition of the western economies was still very weak, but that did not seem to be sufficient to prevent a continuing normalisation of economic activity, with GDP returning slowly towards pre-recession trends.

We now know that these expectations were extremely complacent. Real GDP growth in the US has slumped to around 1 per cent annualised in the first half of the year, and continental Europe has performed no better in Q2. Forecasters like Goldman Sachs and JP Morgan now estimate that the probability of renewed recession in the US is around one third. So what has gone wrong? 

Opinion is sharply divided about what the Fed intended to signal in the statement issued on Tuesday. Some have seen the statement as very dovish, because it said that the Fed intended to leave short rates at “exceptionally low levels” until mid 2013 – the first time that a specific date of this sort has ever been set by the FOMC.

Others, however, concluded that the statement contained nothing really new, since the markets had already assumed that short rates would be close to zero for the next two years. Furthermore, the fact that there were three dissents from the majority decision has led some to deduce that the further large step to more quantitative easing (QE3) is still a long way off. On this view, nothing really changed. 

S&P has received some deserved criticism for the timing and nature of its decision to downgrade the long-term sovereign credit rating of the US on Friday. (See for example these excellent critiques by Clive Crook and Paul Krugman.)

Although S&P’s strictures on the path for US debt and the dysfunctional nature of Washington’s recent political games seem valid, what can the ratings agencies actually tell us about the creditworthiness of the US that we do not already know? Very little. And why did they pick the most volatile day in financial markets since the Lehman crisis to deliver their opinions on a debt problem which, by their own reckoning, will play out over at least a decade? 

Global financial market confidence has collapsed, and visions of the 1930s are flooding back. Recession probability models are flashing red: some suggesting there is now more than a 50 per cent probability of America entering recession before the end of the year. The world’s advanced economies now need an unlikely combination of luck and wise policy to avoid a double dip.

The recent fall in equities represents a belated recognition by the markets that the global economy has been much weaker than consensus economic forecasts indicated earlier in the year. Unlike last summer, when the same thing happened, the markets have also begun to recognise that policy makers have little ammunition left in the locker to combat the downturn.

The political will needed to ease fiscal policy, even temporarily, has evaporated on both sides of the Atlantic. And monetary policy has been hamstrung by the rise in inflation, which has clearly changed the thinking of the Fed. So where is the escape route?