Global economic uncertainty
Earlier in the year, economic life seemed so straightforward. Growth around the world was buoyant. Inflationary pressures were building. Excess liquidity - however defined - was a major worry. The vast majority of central banks were planning on raising...
Earlier in the year, economic life seemed so straightforward. Growth around the world was buoyant. Inflationary pressures were building. Excess liquidity - however defined - was a major worry. The vast majority of central banks were planning on raising interest rates.
Over the past few weeks, though, this consensus has completely broken down. Investors do not know what to think. Should they still be worried about inflation? Or, instead, should they fret about a sub-prime-induced recession? Should they regard the US Federal Reserve's recent interest-rate cuts as temporary aberrations, with rates likely to rise again next year? Or are we on the verge of a sustained period of interest-rate reductions in the US, the UK and elsewhere?
It is not just investors who have these worries. Policymakers, too, are feeling distinctly uneasy, realising they are the victims of events seemingly beyond their control. To be fair to the world's central bankers, they had been warning for some time about the perils of excessive leverage and the dangers of unnecessary risk-taking. And perhaps there were too many deaf ears around. The problem now, though, is not so much the abandonment of the old consensus but, rather, the adjustment to a new one. The sub-prime shock has thrown so many issues up in the air that no one, yet, knows quite how they will eventually fall to the ground.
For the time being, people content themselves with stories. They reassure themselves that what will happen now will, in some ways, mimic tales from the past. And, for optimists, the obvious stories to turn to are those which had happy endings.
In 1998, there was the financial crisis associated with the collapse of Long Term Capital Management (LTCM), the hedge fund whose managers made bets in Asia and Russia which ultimately went horribly wrong. However, at the time Alan Greenspan, saved the day through a series of interest-rate cuts. Despite warnings to the contrary, the end was not nigh and, shortly after the LTCM collapse, the developed world embarked on a dot.com fuelled economic boom.
Maybe we are again going through an LTCM moment. However, why focus on that episode alone? While there are similarities - a financial crisis, a couple of US interest rate cuts, a firm response from equity markets - there are also plenty of differences. LTCM was a one-off event, an isolated incident that threatened to bring down the financial system but ultimately failed to do so. The latest round of difficulties seems more complicated. There have already been bank failures in Germany, the UK and, with the recent demise of NetBank, in the US. This, therefore, is a period of sustained uncertainty. Trust - or lack of it - has become a major issue.
When LTCM struck, the US economy was in a relatively healthy state. Today, US economic fundamentals look a lot more worrying. The housing market has been in dire straits for a couple of years now. Only recently have house prices started to decline. As credit conditions are tightened in the months ahead, there is a good chance that prices will fall even further. And this story is unlikely to be confined to the US alone. Housing markets also look vulnerable here in the UK, as well as in Spain, Ireland and, possibly, France.
Perhaps the biggest difference, though, between 1998's LTCM crisis and the latest set of problems is the inflationary backdrop. During the 12 months leading up to LTCM's autumn collapse, the Asian crisis and Russian debt default had given rise to major disinflationary trends in the industrialised world. The US dollar was strong, as more and more investors fled emerging markets in a flight to US quality. Simultaneously, commodity prices were in a state of collapse, reflecting the economic implosions taking place in the emerging world. Back then, cutting interest rates was relatively easy.
The economic landscape today could not be more different. With oil prices at around US $80 per barrel and with food prices rising swiftly, the global inflationary picture is nothing like as benign. This contrast reflects the improved fortunes of many emerging markets. Wherever you look - China, India, Russia, the Middle East and many parts of Latin America - growth has proved surprisingly resilient in the face of heightened caution in the US and elsewhere. Many emerging economies are on the fast track to prosperity - and that, in turn, means lots of demand for energy and food.
Moreover, many of these countries are partially dependent on the US Federal Reserve for their monetary policies, courtesy of currency regimes which, to a greater or lesser degree, are tied to the US dollar.
These currency regimes may not last the course but they point to even more growth and still higher inflation in emerging markets in coming months. The reason is simple. What emerging markets need, given their already robust economies, is higher interest rates. However, due to the state of the US economy the US Federal Reserve is more likely to lower interest rates. Of course, they could choose to raise interest rates independently of decisions reached in Washington, but that would undermine the currency regimes their policymakers seek to protect.
Continued robust growth in emerging markets points to persistent upward pressure on commodity demand and, hence, commodity prices. For the industrialised world, inflationary pressures may therefore remain elevated even if growth is slowing. Whereas in the late 1990s, US growth was strong but inflation was low, there is now the risk that growth weakens with inflation remaining stickily high. What, then, should central banks do? Cut interest rates in the hope that inflation eventually subsides? Or leave rates unchanged, risking a collapse in economic activity?
For the US Federal Reserve, rapid rate cuts might eventually have to be the order of the day. Politically, it is difficult to imagine US policymakers presiding over rising unemployment and shrinking economic activity, whatever the rate of inflation. The story, though, might not end there. Falling US interest rates would make the control of inflation even more difficult within the emerging world, eventually increasing the temptation to "go it alone" and leave the US dollar to its own destiny. Might this lead to a US dollar collapse, a loss of US monetary credibility and the end of an economic pax Americana?
It may not go that far but the world economy might end up with a mixture of weak growth, sticky inflation and, ultimately, a loss of confidence in the US dollar's status as a reserve currency.
• This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Over the past few weeks, though, this consensus has completely broken down. Investors do not know what to think. Should they still be worried about inflation? Or, instead, should they fret about a sub-prime-induced recession? Should they regard the US Federal Reserve's recent interest-rate cuts as temporary aberrations, with rates likely to rise again next year? Or are we on the verge of a sustained period of interest-rate reductions in the US, the UK and elsewhere?
It is not just investors who have these worries. Policymakers, too, are feeling distinctly uneasy, realising they are the victims of events seemingly beyond their control. To be fair to the world's central bankers, they had been warning for some time about the perils of excessive leverage and the dangers of unnecessary risk-taking. And perhaps there were too many deaf ears around. The problem now, though, is not so much the abandonment of the old consensus but, rather, the adjustment to a new one. The sub-prime shock has thrown so many issues up in the air that no one, yet, knows quite how they will eventually fall to the ground.
For the time being, people content themselves with stories. They reassure themselves that what will happen now will, in some ways, mimic tales from the past. And, for optimists, the obvious stories to turn to are those which had happy endings.
In 1998, there was the financial crisis associated with the collapse of Long Term Capital Management (LTCM), the hedge fund whose managers made bets in Asia and Russia which ultimately went horribly wrong. However, at the time Alan Greenspan, saved the day through a series of interest-rate cuts. Despite warnings to the contrary, the end was not nigh and, shortly after the LTCM collapse, the developed world embarked on a dot.com fuelled economic boom.
Maybe we are again going through an LTCM moment. However, why focus on that episode alone? While there are similarities - a financial crisis, a couple of US interest rate cuts, a firm response from equity markets - there are also plenty of differences. LTCM was a one-off event, an isolated incident that threatened to bring down the financial system but ultimately failed to do so. The latest round of difficulties seems more complicated. There have already been bank failures in Germany, the UK and, with the recent demise of NetBank, in the US. This, therefore, is a period of sustained uncertainty. Trust - or lack of it - has become a major issue.
When LTCM struck, the US economy was in a relatively healthy state. Today, US economic fundamentals look a lot more worrying. The housing market has been in dire straits for a couple of years now. Only recently have house prices started to decline. As credit conditions are tightened in the months ahead, there is a good chance that prices will fall even further. And this story is unlikely to be confined to the US alone. Housing markets also look vulnerable here in the UK, as well as in Spain, Ireland and, possibly, France.
Perhaps the biggest difference, though, between 1998's LTCM crisis and the latest set of problems is the inflationary backdrop. During the 12 months leading up to LTCM's autumn collapse, the Asian crisis and Russian debt default had given rise to major disinflationary trends in the industrialised world. The US dollar was strong, as more and more investors fled emerging markets in a flight to US quality. Simultaneously, commodity prices were in a state of collapse, reflecting the economic implosions taking place in the emerging world. Back then, cutting interest rates was relatively easy.
The economic landscape today could not be more different. With oil prices at around US $80 per barrel and with food prices rising swiftly, the global inflationary picture is nothing like as benign. This contrast reflects the improved fortunes of many emerging markets. Wherever you look - China, India, Russia, the Middle East and many parts of Latin America - growth has proved surprisingly resilient in the face of heightened caution in the US and elsewhere. Many emerging economies are on the fast track to prosperity - and that, in turn, means lots of demand for energy and food.
Moreover, many of these countries are partially dependent on the US Federal Reserve for their monetary policies, courtesy of currency regimes which, to a greater or lesser degree, are tied to the US dollar.
These currency regimes may not last the course but they point to even more growth and still higher inflation in emerging markets in coming months. The reason is simple. What emerging markets need, given their already robust economies, is higher interest rates. However, due to the state of the US economy the US Federal Reserve is more likely to lower interest rates. Of course, they could choose to raise interest rates independently of decisions reached in Washington, but that would undermine the currency regimes their policymakers seek to protect.
Continued robust growth in emerging markets points to persistent upward pressure on commodity demand and, hence, commodity prices. For the industrialised world, inflationary pressures may therefore remain elevated even if growth is slowing. Whereas in the late 1990s, US growth was strong but inflation was low, there is now the risk that growth weakens with inflation remaining stickily high. What, then, should central banks do? Cut interest rates in the hope that inflation eventually subsides? Or leave rates unchanged, risking a collapse in economic activity?
For the US Federal Reserve, rapid rate cuts might eventually have to be the order of the day. Politically, it is difficult to imagine US policymakers presiding over rising unemployment and shrinking economic activity, whatever the rate of inflation. The story, though, might not end there. Falling US interest rates would make the control of inflation even more difficult within the emerging world, eventually increasing the temptation to "go it alone" and leave the US dollar to its own destiny. Might this lead to a US dollar collapse, a loss of US monetary credibility and the end of an economic pax Americana?
It may not go that far but the world economy might end up with a mixture of weak growth, sticky inflation and, ultimately, a loss of confidence in the US dollar's status as a reserve currency.
• This report was compiled by Peter Calleya, Manager Corporate Strategy & Research, HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.