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04 March 2024

Fed policy may not be enough to turn around economy

By Nitin Nambiar


Monetary policy may not be enough to strengthen the economic future of the United States in a stagflation scenario, even as recessionary pressures scale down the growth outlook for the global economy, a senior economist has said.


While the central scenario for global economy remains rather robust for the next two years, the probability of a “highly adverse” outcome has “increased somewhat”, with a number of plausible stress scenarios meriting serious consideration, according to Pierre Cailleteau, chief international economist at Moody’s Investors Service.


One of the three plausible stress scenarios this year in the US is the risk of stagflation – which is the combined risk of a recession and a significant increase in inflation –  triggered in part by a sharp broad-based depreciation of the dollar, Moody’s said in a report “Mapping the near future: Macro stress scenarios for 2008-09”.


The report outlines a central scenario for the world economy in 2008-09, followed by three global risk scenarios.


“The stagflation scenario is not our central scenario. However, it precisely captures the hypothetical risk monetary policy may be unable to strengthen growth, while at the same time a number of inflationary factors take hold, such as imported inflation because of a further decline of the dollar,” Cailleteau told Emirates Business.


The US Federal Reserve on Wednesday cut a key interest rate by half a percentage point as part of an aggressive effort to halt a sharp slowdown in an economy hit by a housing slump and a credit crunch.


The cumulative 1.25 percentage point reduction in the benchmark overnight rate in less than two weeks ranks among the most abrupt rate-cutting sprees in the modern history of the US central bank.


A lot of the recessionary pressures currently in the US are consumer-oriented, meriting a monetary policy approach, according to Mary Nicola, economist at Standard Chartered bank. “The Fed is stepping in to prevent a recession by cutting rates. Whether it [recession] turns out to be mild or severe remains to be seen.


“The Fed’s looking to boost market sentiment by cutting rates. The strategy has been effective in the past. But, whether or not it will be enough to strengthen a grim growth outlook for the US, we’ll have to wait and watch,” Nicola said. Standard Chartered said last week that it expected US growth to slow down to 0.5 per cent this year.


Besides stagflation, Moody’s lists “sharp decoupling” and “stagnation’ as the two other “plausible risk scenarios” for the global economy. “By ‘plausible’, we mean scenarios to which we attach a subjective probability of between 10 and 25 per cent,” Moody’s said. “Below 10 per cent, the scenario is too extreme to be useful; while higher than 25 per cent, it is downside variant of the central scenario.


“In a sharp decoupling scenario, the US economic and financial outlook turns very negative [with recessionary forces taking hold over the period, associated with a bank ‘capital crunch’ as in the late 1980s] and the rest of the world decouples to a greater degree in emerging market economies (EMEs) or lesser degree in Europe. As a result, the dollar depreciates further, but without crisis, and the dollar bloc keeps pegging its exchange rates – creating further trade tensions,” the report said. Moody’s predicts a 25 per cent probability of this scenario over the next two years.


In a stagflation scenario, the world economy reaches another equilibrium through a stimulation of domestic demand in EMEs (notably Asia), while growth in mature economies remains rather weak as a result of the financial healing process, Moody’s said in the report. “Through an appreciation of EME currencies [de-pegging of the yuan and Gulf countries] and domestic price pressures in Asia, inflation creeps up in the US, and more generally in the world,” the report said.


Cailleteau said that countries in the Gulf may keep the exchange rate pegged to the dollar, even as the downside of such a policy increases. “Our central scenario is that they [GCC countries] keep the exchange rate pegged to the dollar, even though the inconvenience of such a policy increases. But, this is not inconsistent with the fact that some countries may create some breathing space through limited flexibility or appreciation,” Cailleteau said.

The agency predicts a 15 per cent probability of the “stagflation” scenario.


“In a stagnation scenario, the sustainability of the debt accumulated in recent years [households, corporate, some countries] is called into question,” the report said.

But, while the “stagnation” scenario remains a possible stress scenario for 2008-09, the agency predicts only a 10 per cent probability of the scenario.


As part of its central scenario, Moody’s predicts continued robust growth globally, at around 3.2 per cent this year and 3.6 per cent for 2009 respectively, against 3.7 per cent last year and 3.9 per cent in 2006. There will be increased differentiation between the group of advanced economies and the emerging economies, according to Moody’s, with the former slowing down notably with a below potential performance in the US, which faces recessionary forces (around 1.8 per cent on average for 2008 and 2009) and close to potential in Europe and in Japan.


The latter will maintain a strong momentum, but below the 7.5 per cent of 2007 – with China, India and Russia posting respective growth rates of around 10, eight and 6.5 per cent.



Inflation forecast


On the inflation front, the tensions will be more on fast-growing emerging market economies (EMEs) with an average inflation in excess of five per cent for the EMEs, the Moody’s report said. Average inflation in the advanced economies will be around two per cent.


The report predicts buoyant international trade, especially among the EMEs, with increased differentiation resulting in higher short-term interest rates in EMEs – leading to more capital inflows. It predicts stable to declining interest rates in advanced economies.

The liquidity/credit stress on global financial markets will slowly subside through this year, with banking reintermediation denting profits and weighing on credit extension, but not leading to a credit crunch, Moody’s said.