5th July 2010

Growth and inflation, or is it a double dip and recession?

Further reflections on the inflation/deflation debate and what it means for economic prospects.

I recently wrote a note on inflation which came to the conclusion that, despite the policy of aggressive monetary easing in the long term representing a risk to higher prices, in the near term the risks of deflation had risen. This piece is supplementary, following the recent Budget in the UK and looking at what the bond markets are signalling after the large recent moves in yields in the UK and elsewhere, with regard to growth and inflation prospects.

The UK Budget and beyond

The maiden Budget from the newly formed coalition government did not come as a surprise to the market despite its austerity. This was because the politicians had been careful to flag the nature of the Budget in advance due to its likely unpopularity. In the event, it could have been even more severe, especially on the proposed tax increases, but it will still create a large fiscal drag for the economy for the lifetime of this Parliament.

As the leaders of the G20 meet in Toronto for their summit to discuss the global economy the main topic of discussion has been the dilemma facing policymakers between fiscal contraction to reduce the deficit and how to sustain economic recovery. A divergence of opinion has emerged led by President Obama on the one hand - warning the fiscal measures must not be too severe or they may endanger the fragile recovery - and, on the other hand, Chancellor Merkel of Germany and David Cameron championing the need to restore the health of public finances. As my previous note explained, the policymakers face a delicate balancing act between the two views.

Therefore, what does the Budget mean for the UK's growth and inflation outlook?
The Government's projections at the time of the Budget included a slight downgrade for the level of growth in 2010 (to 2.3% from 2.6%) but upgrades for the following years as the economy recovered on a stronger financial footing. I believe such optimism is misplaced and the bond markets are already signalling as much.

If the Chancellor is to be proved correct in his forecasts, the fiscal contraction in the public sector must be offset by expansion elsewhere via increasing exports and higher household and company spending, in the foreign and private sectors respectively.

Within the context of the current global economic environment I think GDP growth will fall short of expectations. Following the credit crunch of 2007-8, interest rates have been cut to near zero, which limits the MPC's ability to stimulate growth through monetary policy without resorting to QE again (I believe that they will do so).

Furthermore, global demand remains weak with most of the developed economies facing similar fiscal contraction to the UK. The escalation of the sovereign debt crisis in Europe has sapped confidence not only in markets but also within the banking sector, so that the availability of credit has become restricted just at a time when it is desperately needed.

RDR