The synchronization of the next cyclical slump in the US, in Japan, and in Europe will deepen the forthcoming economic and social crisis in 1999/2000.
HK
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Extracts from the OECD Economic Outlook [preliminary version] No. 64, November 1998:
i) pp. 28-31:
What might a downside scenario involve?
Risks are interdependent
The risks described above are highly interdependent, and most of them, if they were to materialise, would make at least some of the others more likely. If several of these were to occur, either simultaneously or in rapid sequence, they would set further events in train, probably including:
- renewed declines in oil and commodity prices, due to a continuing fall in global demand, which would adversely affect producing countries (see Box I.5);
- a reactive easing of monetary policy, probably first in the United States but eventually also in Europe;
- a decline of both the dollar and the yen, reflecting monetary easing in the United States and growing economic weakness in Japan.
A scenario has been prepared which considers what might happen if some event, probably outside the OECD area, triggered some of these risks. The assumptions which underly it are described in detail in Box I.6 and in the Appendix at the end of this note. Two variants involving alternative monetary policy responses in the United States and Europe were analysed. In the first, the authorities in both regions are assumed to ease only cautiously, bringing interest rates down in line with inflation, but no more, so that real interest rates evolve as in the central projections. In the second, the authorities of both regions ease more aggressively in response to developments so that real interest rates fall. This latter response is generally in line with past behaviour during periods of recession. In Japan, nominal interest rates are so low in the central projections that there seems to be little scope for further easing of monetary conditions, apart from what would be implied by yen depreciation.
A pessimistic scenario suggests that growth could nearly stop in 1999 if risks materialise
The scenario suggests that in the case where monetary easing takes place cautiously, there would be essentially no growth next year in the OECD area as a whole (Table I.8). The United States would experience a recession, Japan’s economy would continue to contract and growth in the European Union would fall to below 1 per cent. More aggressive monetary easing would mitigate the deflationary forces and produce a somewhat better outcome, but not enormously so.
ii) pp. 69-74:
UNITED STATES
The economy appears to have reached a cyclical high point in 1998. The year-on-year growth rate peaked at 4.2 per cent in the first quarter. Following a deterioration in corporate profits linked to a strong dollar, accelerating labour costs and lower external demand in Asia and Latin America, economic growth is projected to slacken progressively to not much more than one per cent in the middle of 1999. The slowdown should ease tensions in the labour market and help stabilise wage increases. Nevertheless, with labour costs running ahead of prices, the fall in profits could accelerate, raising the risk of a drop in equity prices and a significant fall in investment.
In the current situation distinguished by slowing demand growth, low inflation and financial turbulence some further reduction in interest rates seems appropriate. The projections are indeed based on the federal funds rate being lowered to 4.50 per cent during 1999 from its current level of 5 per cent. However, were the downside risks to the projections to materialise, larger cuts might be necessary, especially if the current instability in financial markets were to persist. As to fiscal policy, a continued reduction in debt over the medium-term would help prepare public finances for the ageing of the population.
Strong domestic demand kept the economy buoyant ...
Domestic demand remained strong in the first half of 1998. Household consumption was particularly buoyant, with spending running well ahead of income, so pushing down the saving ratio. In major part, this appears to have been the result of a surge in the stock market, with the value of personal equity portfolios rising, relative to incomes, to levels not seen since the early 1960s. Business investment was also very buoyant, especially for computer equipment. Part of this strength in domestic demand was offset by the weakness of external trade, with an appreciation of the dollar and a standstill in foreign demand leading to a widening of the current account deficit. Nonetheless, output growth continued at the same strong pace as seen in 1997, while falling oil, commodity and import prices ensured that the rate of inflation continued to fall through the first half of 1998.
... but signs of slackening emerged mid-year
By the second quarter of 1998, some signs of slackening in activity started to emerge. Although consumer spending and housing remained strong, the fall in exports accelerated and business investment were weaker. The slackening in the growth of demand continued in the third quarter with capital formation and foreign sales dropping. But with stockbuilding surging, output growth held up more than expected. The labour market has remained tight, even though the unemployment rate edged up after reaching a twenty-eight year low, at 4.3 per cent, in April.
As profits weakened and credit spreads widened, the stock market fell
Strong demand for labour has led to a small, but significant, acceleration in both total employment costs and hourly earnings. This development was not offset by productivity gains, thus leading to an increase in the growth of unit labour costs, at a time when competitive pressures, stemming from the strong dollar, held back the increase in domestic prices.
Consequently, domestic after-tax corporate profits fell in the second quarter. This development, coming after a four-year period in which the share of profits in GDP only increased slightly, was associated with a marked downward revision of earnings expectations. The valuation of these lower earnings was also affected by financial turbulence that raised risk premia world wide and resulted in a substantially higher gap between the yields of high quality corporate bonds and government securities. Indeed, by early October, this spread was nearly 190 basis points, a level not seen in the previous forty years. With the medium-term outlook for corporate earnings being revised down and the risk premium up, share prices were over 20 per cent below their early summer highs.
Government bond yields dropped ...
The heightened perception of risk in financial investments was accompanied by a marked rise in the price of government securities and a relatively flat yield curve for maturities over two years. At the long end of the market, most of the fall in yields appears to reflect a strong desire for liquidity and pronounced easing in inflation expectations. Bond markets have also benefited from the move of the federal budget into a surplus of one per cent of GDP, as discretionary spending caps limited the growth of outlays and revenues were boosted by high tax receipts on realised capital gains taxes.
... and official rates followed
The Federal Reserve, given the strains in the financial system and feeling that the risks of weaker output exceeded the possibility of higher inflation, lowered the federal funds rate by 50 basis points in two stages during September and October. Moreover, the second of these was not made following a scheduled meeting of Federal Open Market Committee. These cuts appear to have restored some liquidity to capital markets after the precipitous fall in new issues of equity and below-investment quality bonds in the summer, but domestic risk premia only eased slightly. Although bank lending has provided some substitute, credit standards appear to have been tightened. Market expectations of further cuts have also led to some steepening in the yield curve and weakening of the effective exchange rate of the dollar to slightly below its first half average. Moreover, the equity market staged a marked recovery eliminating a large part of its earlier losses. With the economy expected to weaken further, cuts of 50 basis points in the federal funds rate are built into the projections.
Falling asset values will slow consumption ...
The slowdown in the economy is expected to become more pronounced in the first half of 1999. Overall, growth may be around 1½ per cent next year, but it should pick up thereafter as the impact of lower short-term interest rates is felt and the external environment improves. The Federal budget surplus should be reduced both by slower growth and by the decision to exceed previously legislated spending caps by $20 billion (¼ per cent of GDP). At the origin of the slowdown is the reaction of companies and households to the marked weakening of corporate profits that has occurred during 1998. Such a movement worsens domestic demand through two channels. Lower equity values are projected to result in increased household saving. With income growth also slowing, this generates a slackening of consumers expenditure to a more sustainable growth rate. In addition, in 1999 corporations are expected to scale back investment outlays, so that investment is projected to grow only slightly and may even fall in nominal terms. Nevertheless, the corporate sector will still have a relatively high financial deficit and will have to rely more on the banking system for credit. This weakness in domestic demand is partially offset by a smaller drag on the growth of the economy from the foreign sector. The adverse impact of the past appreciation of the dollar gradually wears off and export markets are projected to recover -- so boosting exports. Indeed, this movement is the principal reason why growth is projected to pick up in 2000, to 2¼ per cent, even though the current account deficit continues to widen.
... and raise unemployment, thus bringing output closer to its equilibrium level
With growth remaining below potential from the second half of 1998 onwards, some increase in the unemployment rate is projected. Such a move should relieve pressures in the labour market and help to stabilise wage increases. However, with productivity growth slackening, the expansion in unit labour costs may remain above that of prices, even though the latter may accelerate somewhat as the downward pressure from imports prices lessens. As a result, corporate profits are expected to weaken further throughout the projection period.
The reaction of financial markets to lower profits will be critical
Apart from the downside risks stemming from developments in the world economy, the main risk to these projections stems from the possible reactions of corporations and financial markets to weaker profits and from the possibility of a marked reduction in credit flows. Companies, which are relying on continued extensive borrowing to maintain the current level of investment, may indeed see their credit ratings falling in line with their declining profitability. This might further reduce their access to funds and increase their cost of borrowing, making investment less profitable. At the same time, another drop in the stock market could depress consumer sentiment further and push the economy towards recession, thereby lowering imports. While larger cuts in official interest rates could help to stabilise the situation, they might also lead to a further fall in the external value of the dollar which could put pressure on domestic inflation. On the other hand, the reaction of consumers to recent stock market falls is uncertain. In the near-term, households might consider their current level of wealth is still sufficient, lessening the need to increase saving. As a result, personal consumption would be better maintained than in the central projections, thereby limiting the extent of the slowdown in economic growth.