GDP growth in the major industrialised economies reached almost 3 per cent in 1994, which is a much stronger performance than seemed likely a year ago. Neither the rise in short-term interest rates that took place in the Anglo Saxon countries last year, nor the setbacks in bond and equity markets, are enough to pose a serious threat to global growth in 1995. However, within the OECD growth rates are likely to converge somewhat toward an average of around 3 per cent, as the Anglo Saxons slow and the economies of continental Europe and Japan speed up.
Inflation risks still appear to be extremely low in 1995, especially now that oil and other commodity prices have subsided a little from the highs seen in the middle of last year. Recent 'running rates' of consumer price inflation are still declining in the OECD area as a whole, and in many countries strong disinflationary forces still exist. These stem from the existence of ample spare capacity and high rates of unemployment. For the developed countries as a block, and especially in Japan and continental Europe, this margin of spare capacity is unlikely to have disappeared even by the end of 1995. In those economies which led the others out of recession, such as the US and the UK, the amount of slack is less clear. However, providing growth moderates in these economies during 1995, any uptick in inflation should prove modest.
This in turn has important implications for monetary policy. In those countries where the existing margin of spare capacity is being absorbed rapidly, such as the US and UK, interest rates are likely to be raised relatively sharply in the coming months to ensure that growth slows to a more sustainable pace. Elsewhere, while it is likely that interest rates have troughed, any upward move during the course of the year is likely to be much more modest.
US economic activity accelerated in the final months of 1994 to an annualised rate of growth in excess of 4 per cent. The key force driving this expansion has been a mutually reinforcing combination of growth in jobs, income and household spending that is more characteristic of the early stages of recovery from recession than a mature business expansion. Strong export growth and a willingness by firms to build up stocks have also provided considerable support. These developments have to date thwarted the Federal Reserve's efforts to slow the economy.
The stubborn buoyancy of the US economy will test the disciplinary skills of Federal Reserve officials in the coming months. Although US short-term interest rates rose by 250 basis points during 1994, taking the federal funds rate up to 5.5 per cent, they seem set to rise further. Federal Reserve chairman Alan Greenspan indicated at the end of last year that he expected an imminent pickup in finished goods price pressure, and he warned that failure to resist this could lead to a more damaging rise in inflationary expectations.
With capacity utilisation high and rising, and unemployment low and falling, Fed officials are not going to sit idly by hoping that the economy will slow. It seems likely, therefore, that monetary tightening will be the rule rather than the exception over the coming months.
How much US interest rates will need to rise to tame the economy is impossible to say with any precision. Historically, the amount of tightening needed to restrain growth has ranged widely depending on what other factors were influencing economic activity. The uncertainty is made worse by the apparent absence of the effects of earlier policy tightening on growth to date.
A reasonable assumption is that the Fed will raise interest rates by an average of around 50 basis points at each of its scheduled meetings in the early months of 1995. By this rule federal funds would be at about 7 per cent by the middle of 1995, by which time slower growth should be apparent. On these assumptions, growth in the US may slow to an annual rate of around 3-3.5 per cent in the first half of the year and then to 2-2.5 per cent in the second half, after recording 4 per cent growth in 1994.
In Japan, the economic recovery this year is likely to be much more modest than elsewhere in the world. This reflects the vast amount of spare capacity created by the depth of the recession, which will stifle any significant recovery in investment for at least another 12 months. Consumer confidence remains fairly depressed and, unlike last year, households will not feel the benefit of significant cuts in taxes. In consequence GDP growth could be restricted to only 1.5 per cent this year after growth of less than 1 per cent in 1994.
Japanese short-term interest rates stabilised during the second half of 1994 and monetary policy is likely to remain broadly on hold for much of this year. However, as indications of stronger growth start to appear later in the year, there may be a willingness by the Bank of Japan to allow short-term interest rates to edge higher. Even so, three month interest rates are unlikely to move above 3.5 per cent during the course of the year, thereby keeping interest rates in Japan the lowest throughout the OECD area.
In Europe, economic growth strengthened in all countries during 1994. This reflected the effects of the substantial easing in monetary policy since summer 1992. The UK was at the top of the European growth league in 1994, with GDP rising by almost 4 per cent. Despite a much earlier tightening in monetary and fiscal policy than elsewhere in Europe, the UK seems set to remain close to the top of the European growth table in 1995. UK exporters will reap the benefits of a further strengthening in overseas demand, especially in Europe, and this will keep export growth buoyant. Domestic demand is likely to be boosted by strong growth in fixed investment. Capacity utilisation is running at or above normal levels across the whole economy, and with company finances restored to a very healthy position, firms are likely to step up their investment plans sharply during 1995.
The big uncertainty in the UK relates to consumer spending. There is no question that consumers are still unwilling to enter into large spending commitments, as evidenced by the weak trend in the housing and new car markets, but consumer confidence and spending are likely to be supported increasingly by an improving trend in employment and incomes.
On present policy settings, the UK economy may grow by 3.5-4 per cent in 1995. This is likely to be too fast for the authorities' comfort. To ensure that growth slows to a more sustainable rate by 1996, the Chancellor is likely to authorise further increases in interest rates during the first half of 1995, taking base rates up to around 7-7.5 per cent, before a period of stability ensues.
Elsewhere in Europe, with economic recovery firmly established, there seems little reason to expect any further easing in monetary policy. Equally, it will take a prolonged period of rapid economic growth in many cases before there are pressing domestic reasons for central banks within continental Europe to raise interest rates. Nevertheless, for many European countries the actions of the German Bundesbank are at least as important for the setting of monetary policy as domestic economic conditions.
In Germany, there is a reasonable chance that the Bundesbank will begin to tighten monetary policy rather earlier and by more than is generally expected. During 1993 and 1994, the Bundesbank implemented a considerable easing of monetary policy in an attempt to pull the German economy out of recession. With the German economy growing by around 2.5 per cent last year that policy was clearly successful.
One side effect, though, is that the German economy has returned to normal levels of capacity utilisation much earlier than usual. In this regard the situation is rather different from most other European countries, where capacity utilisation is still languishing at very low levels. If growth continues at its present rate in Germany, which seems likely, it may not be long before inflationary pressures gradually begin to reemerge, in which case the Bundesbank will feel bound to tighten monetary policy. Short-term interest rates could be running at around 6.25 per cent by the middle of the year, about 100 basis points higher than at the end of 1994.
For other European countries this may pose something of a dilemma. However, within many European central banks, the desire to keep their currencies relatively stable against the mark means that interest rates are also likely to head higher throughout much of Europe during 1995.
The extent to which other European central banks follow the German lead will vary from country to country. The keenest are most likely to be those which have experienced significant devaluations in their respective currencies versus Germany over the past two years, such as Spain, Italy and Sweden. In these countries economic growth seems more firmly established and central bankers are likely to be less concerned about the adverse effects of higher interest rates on economic activity and more concerned about the inflationary consequences of any further currency depreciation.
France may have the greatest problem. The recovery in France is less robust and politically it may be more difficult to follow the German lead. Consequently, there may be a smaller increase in French interest rates this year than in Germany, and a weakening in the French franc as Germany begins to tighten.
Developments in the general exchange rate environment are likely to be similar to those which occurred during the final quarter of 1994 when the US dollar began to improve. The big question for the currency markets is central bank credibility. In 1994, where central banks raised interest rates before growth seemed to require one, their currencies did better. For example, the dollar benefited last November from a widespread perception that the US Federal Reserve was determined to tighten monetary policy sufficiently to keep inflation in check. With Federal Reserve officials likely to continue to tighten monetary policy aggressively during the first half of 1995, the dollar should generally rise against most other currencies. Support for the dollar could also come as the US trade deficit begins to stabilise in response to a moderation in US economic growth and strengthening activity outside the US.
However, a large upward move in the dollar against the Deutsche mark or the yen seems unlikely for two reasons. First, the economic recoveries in Germany and Japan will be gathering pace. Thus interest rates in Germany and Japan are also likely to begin to head higher during the course of 1995, thereby limiting the degree of widening in interest rate differentials between the US and other countries. Second, the dollar is not grossly undervalued. On a trade weighted basis, the dollar's real exchange rate is only about 2 per cent undervalued compared with the average value of the dollar over the past five years. If the dollar were to rise by 15-20 per cent from current levels, the US currency would become significantly overvalued. This seems unlikely at a time when a huge trade deficit and a strong appetite for foreign securities are generating a large outflow of dollars from the US.
Sterling seems likely to remain relatively well supported during 1995. The UK authorities have shown a willingness to tighten policy pre-emptively in response to strong economic growth. Provided the Chancellor is prepared to raise interest rates further, as seems likely, interest rate differentials should be maintained in sterling's favour. At the same time there do not appear to be any nasty shocks looming on the economic front; inflation and the current account of the balance of payments are both likely to remain well behaved this year. In normal circumstances, this might be expected to lead to a much stronger outlook for the currency. However, political uncertainty may increase in the UK as the year progresses and this could cap the upside for the pound.
Source: Airline Business
