Deceptive stability could end with a bang

Following the dramatic bailout of Bear Stearns, the financial markets have displayed surprising resilience. Stock markets have recovered, the US dollar has stabilised and beleaguered debt markets have strengthened. But many underlying problems remain unresolved, and threats to the real economy have worsened. Hopes of long-term tranquility are premature.

The economic figures are gloomy. US jobs fell by 80,000 in March, the third consecutive monthly decline. The US unemployment rate rose to 5.1%, the highest level since September 2005, reinforcing the view that the economy may be in recession. The new IMF global forecasts signal worsening prospects for almost all the world’s economies. The IMF is now more pessimistic than the consensus of private sector analysts, particularly for the US.

It is important to be realistic, not overstating the gloom but appreciating that the outlook will remain grim until well into 2009. In the US, the recession will not be too severe, but it is unlikely that we will see an early return to normal growth, as the Fed and the Administration have predicted. At a global level, recession is unlikely, but growth will be weak. The US downturn will cause protracted worldwide damage.

The Bear Stearns rescue confirms that the US authorities are willing to take radical steps, including accepting credit risks, to avoid a major default. The Fed is also deploying aggressively its conventional weapons, injecting liquidity and cutting interest rates.

Rates
The Fed funds rate is likely to fall to 1.75% before mid-2008; a further cut to 1.50% is probable later in the year. In the eurozone, inflation has risen to 3.5%, and the European Central Bank has kept its key rate at 4%. But the gap between German resilience and major risks in Spain, Italy and Greece is causing tensions. With growth slowing, we expect a cut in eurozone rates to 3.75% later in the year. In the UK, Bank rate was cut to 5% on 10 April. But falling house prices point to worsening threats facing the economy. A UK cut to 4.75% is likely in the next two to three months.