The heady days of 2004-2007, when global GDP growth averaged about 5% per annum, seem like a distant memory now. Growth in most countries slowed in the first half of 2008 due in part to monetary tightening, the unprecedented rise in energy prices and dislocations in credit markets. However, global economic activity went into freefall in the fourth quarter of last year as credit markets froze up in the wake of Lehman Brothers' failure. Industrial production in the OECD countries (i.e., the thirty most developed economies in the world) plunged 7.6% in November, the sharpest year-over-year contraction since records began in 1975.
We forecast global GDP will decline 0.3% this year. Although our projection may not sound bad, global GDP has never contracted, at least not since the International Monetary Fund (IMF) began calculating the series in 1970. Every G-7 economy is in deep recession at present, and growth in the developed world likely will remain negative over the next few quarters. The emerging world is hardly immune to the sharp reduction in global trade that is underway. Although not every developing country will experience outright recession, growth in the developing world has already slowed sharply and further weakening seems very likely. Developing economies that had over-leveraged financial sectors – many countries in Eastern Europe would fall into this category – will be especially hard hit. A number of countries, including Belarus, Hungary, Iceland, Latvia, Pakistan and Ukraine, have already gone to the IMF with hat in hand. There probably will be more to follow.
What will turn the situation around? For starters, governments have responded to the crisis by announcing steps to shore up their financial systems. Although the global financial system is hardly back to normal, some segments of the credit markets are starting to function again. In addition, governments are attempting to stimulate their economies via expansionary macroeconomic policies. Significantly lower interest rates and fiscal stimulus should help to stabilize economic activity later this year. The sharp decline in inflation in most countries over the past few months should help to shore up consumer spending by supporting real income. Global growth should be stronger in 2010 than in 2009, but it will probably fall short of its long-run average (3.7% per annum). Underlying all of our projections is our assumption that policymakers will take the necessary steps to prevent the global financial system from locking up again à la last autumn. If that assumption proves to be overly optimistic, then global economic activity would contract even more than our already grim outlook projects.
The U.S. economy has been in recession since December 2007, and it likely will remain there until this autumn. Unlike the strong recoveries that followed the deep recessions of 1973-75 and 1981-82, the upturn that we project will take root later this year probably will be relatively weak, at least initially. Growth in consumer spending probably will be very sluggish over the next few years as consumers repair battered balance sheets and raise abysmally low saving rates. We project U.S. real GDP will grow about 1% in 2010, well below the 3% annual growth rate the economy averaged between 1992 and 2007.
Deep recessions are underway as well in Canada, the Euro-zone and the United Kingdom. On a peak-to-trough basis, real GDP in these economies will probably contract 2 to 4%, which are deep recessions by any measure. Some observers use the word depression when describing the Japanese economy at present. Indeed, Japanese industrial production essentially collapsed in the fourth quarter. Foreign central banks have slashed policy rates in response to the recent freefall in economic activity. The Bank of England has cut its policy rate to 1.00%, and the lower bound of 0% beckons over the next few months. The European Central Bank has been slower to ease policy – its main policy rate currently stands at 2.00% – but we project further rates cuts in the months ahead for the ECB.
Inflation rates in most countries shot higher in the first half of 2008 and commodity prices went through the roof. However, commodity prices have subsequently collapsed as economic growth has slowed sharply. After rising to nearly 6% in 2008, which is the highest rate in about 10 years, global inflation should recede to roughly 2% this year. Although we do not believe the world will experience generalized deflation, some individual countries could experience a period of mild price declines this year.
Dollar Appreciation Should Continue in Near Term
After following a downward trend between 2002 and mid-2008, the trade-weighted value of the U.S. dollar is up about 15% on balance since last July. The dollar's appreciation is not a reflection of a positive near-term outlook for the U.S. economy. Rather, the prognosis for many foreign economies has deteriorated more rapidly than for the U.S. economy since mid-summer. Whereas many investors had expected most foreign economies to avoid recession, it has become glaringly obvious in recent months that those economies will experience their own sharp downturns due to the global nature of the credit crunch.
In our view, the dollar should rally further in the near term. U.S. authorities are generally taking more aggressive steps to stimulate the economy via aggressive monetary and fiscal easing than their counterparts in most other countries. Consequently, signs (or at least expectations) of stabilization and subsequent recovery should show up in the United States before they do in most other economies. Expectations of recovery should be conducive for further dollar strength.
However, the problems facing the U.S. economy are generally more serious than the problems that confront many other economies. Although growth in the United States should turn positive again later this year, the recovery we project will probably be very sluggish. We are usually loath to forecast turning points in exchange rates at some point in the future, but sustained dollar strength against the backdrop of very slow U.S. economic growth does not seem to be very credible. Therefore, the dollar could give up its gains and begin to depreciate later this year or early next year as the reality of a very slow U.S. economic recovery becomes painfully clear to investors.