NEWS / Foreign Exchange

We've Seen This Movie Before

U.S. Review

We've Seen This Movie Before

Today marks the 20th anniversary of Black Monday and some of the same uneasiness that was felt back then is with us today. The 1987 Stock Market Crash proved to be far less destabilizing as many had feared. There was no recession, much less depression in the aftermath of the Crash, and the Dow Jones Industrial Average actually ended 1987 at a higher level than it started the year.

The Federal Reserve did what it needed to do in the aftermath of the Crash. The Fed cut the federal funds rate by three-quarters of a percentage point over the course of three months. Soon the Fed found that economic conditions had not deteriorated anywhere as much as had been feared. The economy proved to be quite resilient, with real GDP growth actually accelerating to a 4.1 percent pace in the year following the Crash. Even in the quarter that the Crash occurred, the economy was growing much faster than many realized. Real GDP surged at a 7.2 percent pace in the fourth quarter of 1987. With all this growth, the Fed had to raise interest rates only five months after the crash.

Are There Any Lesson From 1987 That We Can Use Today?

While the origins of the 1987 Stock Market Crash and today's Mortgage Market Meltdown/Credit Market Squeeze are quite different, the impact on the economy may prove to be remarkably similar. One of the reasons why the economy grew so solidly back in the 1980s was that we saw a dramatic decline in the dollar and sharp turnaround in net exports. Domestic demand did slow roughly as expected.

We are a seeing a similar turn of events today, with export growth nearly offsetting the entire decline in residential construction. Businesses tied to the domestic economy are struggling while those tied to global economic conditions are seeing solid gains in orders and earnings. Focusing solely on the negatives ignores the economy's propensity to constantly evolve. The second half of the expansion tends to be driven by different forces than the first half. Typically, economic growth in the first half of the expansion is driven by consumer spending and housing, while growth in the second half is driven by exports and business fixed investment. That is the pattern we saw in the long economic expansions of the 1980s and 1990s and also appears to be playing out today.

This week's economic data generally shows moderating economic conditions. Industrial production rose just 0.1 percent in September, following no change the previous month. Recent data on industrial production have been jostled about by unseasonably warm weather, which boosted utility output, and contract negotiations with the major motor vehicle producers, which distorted production schedules. Output of industrial equipment has actually held up well throughout all this volatility and has risen 4.1 percent over the past year, or more double the increase in overall industrial production.

Housing starts fell much more than expected, with overall starts plunging more than ten percent. Most of the decline was in the volatile multi-family sector. Starts of single-family homes only fell 1.7 percent. The less volatile permits figure fell as well, indicating further weakness in months to come.

On the CPI, it is important to note that the CPI ended the third quarter on a high note, despite rising only 1.0 percent at an annualized rate in the quarter. This high ending point will make the annualized growth rate in the fourth quarter that much higher. Inflation could play a key role in real GDP growth in both the third and fourth quarters, as the GDP deflator is set to be far higher in the fourth quarter, eating into real growth.

Global Review

This week, the International Monetary Fund (IMF) released its semi-annual World Economic Outlook (WEO), in which it makes projections of growth and inflation for most of the economies in the world. As shown in the chart at the left, the IMF projects that global GDP growth will slow from 5.2 percent in 2007 to 4.8 percent next year. Although the IMF made no changes to its previous forecast for global GDP growth in 2007, it marked down its projection for 2008 by ?? percentage point. If the IMF??™s forecast for next year is realized, however, global GDP growth would still exceed the average of the past 35 years by about one full percentage point. Although we believe the IMF??™s projection for growth next year is a bit high, we have no major quarrels with its contention that global GDP growth should generally remain solid.

The IMF marked down its forecast for growth next year due largely to recent dislocations in credit markets. Tighter credit conditions should slow growth in consumer and business spending. Although credit markets are performing better than a month or so ago, the biggest risk to the IMF??™s forecast is a resurgence of credit market dislocations. As the WEO notes, ???an extended period of tight credit conditions could have a significant dampening impact on growth.???Assuming that credit markets return to normal, the global economy should continue to expand at a solid pace because ???the underlying fundamentals supporting growth are sound and the strong momentum in increasingly important emerging market economies is intact.???

Even if credit markets return to normal, the usually dour IMF notes other risks. Chief among these risks are inflationary pressures, especially among developing nations that are growing very strongly. For example, Chinese CPI inflation has risen rapidly this year. Much of the rise in the Chinese CPI, as well as consumer prices in other developing countries, are attributable to food prices, which generally reflects tight supplies. ???Core??? CPI inflation rates are generally more contained. However, continued strong growth could lead inflation rates to head even higher, especially if oil prices continue to rise, which we discuss below.

Fiscal deficits are a longer-run concern. The IMF acknowledges that most advanced economies have made progress reducing their budget deficits over the past few years. However, ???structural??? deficits remain (see middle chart). That is, most countries are still incurring deficits even though their economies are operating close to full employment. The IMF advises further fiscal consolidation over the next few years. Rising spending pressures associated with aging populations will cause these deficits to widen anew, which could lead to significantly higher long-term interest rates.

One of the implications of the IMF??™s forecast for solid growth next year is that commodity prices are not likely to retreat significantly. Strong global growth over the past few years has helped to lift the price of oil and many other important raw materials to all-time highs (see bottom chart). A supply disruption at a time when global supply is already stretched thin could cause oil prices to soar even higher, which would weigh on global economic growth.