The risk-filled recovery

By Craig Alexander, Senior Vice President & Chief Economist, TD Bank Financial Group

Governments will need to address fiscal deficits.

In order to understand where the world economy is headed and the key risks to the outlook, one needs an appreciation of what brought it to the current state. The crisis in the fall of 2008 put the global financial system and the major economies of the world into a form of cardiac arrest. Financial flows seized up, international trade plunged and domestic demand in most regions declined. The heartbeat of many economies flatlined.

Unprecedented stimulus

The dire prospects for their national economies and the emergence of a “we are all in this together” mentality led central banks and governments to respond to the crisis like a trauma team. The objective was resuscitation and stabilization. In order to accomplish this task, enormous and unprecedented stimulus was injected. The deep and coordinated policy response proved effective. By mid-2009, a faint heartbeat could be heard, and it grew steadily louder over the following months. In December, TD Economics declared that the Global Great Recession had ended, but the outlook was for only a gradual economic recovery.

However, the story in the global economic trauma ward is now becoming far more nuanced. Although the connectivity remains, significant variance in economic performance is starting to unfold. This reflects how various countries and regions are responding to the fiscal and monetary stimulus that was provided.

Strength in emerging markets

It turns out that the policy medicine has some patients recovering so quickly that the stimulus dosage applied now looks too great. The emerging markets of Asia and Latin America, including the newly industrialized economies of Asia, were less affected by financial crisis and recession. Most of their weakness came from exposure to others through trade and finance. Once financial conditions stabilized and the decline in global demand slowed, production rebounded in these regions. The strength in these regions is likely to continue in 2010, with emerging markets being a primary driver of global economic growth.

The challenge is that the limited slump and the strong rebound mean that many emerging market economies no longer require the fiscal and monetary stimulus that has been provided around the world. China best illustrates this situation, which is why China raised bank reserve requirements and tightened lending guidelines in early 2010. However, more policy tightening in China is needed and is likely to take place.

Our assumption is that growth in emerging markets will prove strong in 2010, but cool a bit in 2011 as export growth moderates and as domestic economic activity is reined in a bit. The main risk to the outlook for non-Japan Asia and Latin America is that inflation problems or asset price excesses could develop.

Slow recovery in domestic markets

The story is very different in the industrialized countries, where the policy response is creating its own complications. The fiscal and monetary stimulus has helped to mitigate the depth of the recession and fostered a return of economic growth. The most likely scenario is that growth will continue in 2010 and 2011 but at a relatively subdued pace compared with past economic recoveries. More troubling than the slow pace of recovery is the fact that the policy medicine has created its own set of problems.

The dominant challenge is the enormous fiscal deficits that have been accumulated. This has sparked concerns about the ability of governments to meet their financial commitments. The spotlight has been focused recently on Europe. Greece has been responding to a fiscal crisis, but markets have been worrying about whether other countries are at risk. The message is clear: Countries with large fiscal deficits must develop transparent and credible plans about how they will eventually put their house in order.

Timing the fiscal restraint

In 2011, the declining impact of fiscal stimulus will start to act as a drag in many industrialized economies. Moreover, when spending cuts or tax hikes are implemented in the future, the headwind on the economy will be even greater. So the timing of fiscal restraint is problematic. If governments constrain fiscal policy too much, the patient will suffer. If governments wait too long, financial markets will fret about the value of a country’s debt.

The challenge of fiscal rebalancing will be with us for a long while and augurs for continued moderate economic growth in the developed world over the next several years. There is a material risk that fiscal worries will continue to add to financial market volatility over this period.

The coming fiscal drag has implications for the conduct of monetary policy. The fiscal headwinds and only moderate economic growth imply that inflation is unlikely to become a problem. This suggests that the industrialized world should be only gradually weaned off the monetary policy drip that it is currently hooked up to.

However, keeping monetary policy stimulative does not mean leaving interest rates at their current level. There is a major risk that people will view monetary policy as becoming tight the minute central banks raise rates off their near-zero floor. Keep in mind that a “neutral” level for the U.S. Fed funds rate is close to 4%. Initial rate hikes will represent the U.S. Federal Reserve scaling back the strength of the monetary policy pills, not ending the prescription. As the economic recoveries of industrialized countries gain traction, monetary policy will need to be rebalanced, but the level of interest rates should remain at historically low levels.

A careful rebalancing

The rebalancing in policy must be done very carefully. Raising interest rates too quickly will cause the recovery to lose momentum. Raising interest rates too slowly will create inflation risks. The timing of the policy response will differ by country. From a financial market point of view, the different timing of monetary policy exit strategies could add to volatility.

In conclusion, while TD Economics is committed to the view that the global recovery will be sustained, risks abound. There are risks around the considerable strength of the recovery in emerging markets and the fragility of the recovery in developed nations; there are worries about the size of fiscal deficits and the timing of future fiscal restraint; and there are challenges around the timing and aggressiveness of the rebalancing in monetary policy.

One key message is that the economic projections showing strong economic growth in non-Japan Asia and Latin America, and moderate economic growth in Japan, Europe and North America, belie the likely volatility that is to come in the economic data and financial markets.

In this issue		May 2010
	The risk-filled recovery		A web of credit market risks