A year is a long time in economics. This time last year global economic optimism was high. Europe was in the midst of its strongest growth phase in a decade, Japan was threatening to break out of the vicious spiral of recession that had engulfed it for more than a decade, and the longest post-war expansion in the US was showing few signs of losing momentum.
Today it is all very different. Japan is back in recession, the US economy is skirting negative growth, and Europe is struggling to stay above water, having lost its momentum suddenly and sharply over the past six months.
The policy options in all three jurisdictions are not that obvious at this stage. The US Federal Reserve has slashed interest rates and the Bush administration has pushed through reasonably aggressive tax cuts, but still the US economy is failing to lift off. In Japan, interest rates have been taken back to zero and monetary conditions were eased further recently in a desperate attempt to rescue a pretty hopeless situation.
The response in Europe has been a lot less aggressive, with just one rate cut of a quarter per cent delivered to date. So while the US and Japanese authorities have already used the bulk of their ammunition, the Europeans at least have some fire power in store, but the question is whether they will use it or not? Next week will tell a lot in that regard.
Next Thursday, the governing council of the European Central Bank (ECB) returns from its summer break to deliberate on monetary policy. Since it broke for holidays we have seen further compelling evidence of just how sluggish economic activity in the area has become. In Germany, unemployment is rising in the face of massive job layoffs, business sentiment is poor and the Bundesbank has effectively ruled out any growth in the German economy in the second quarter.
At a euro-zone level, industrial production has declined for the past two quarters and it is probable that the area experienced no GDP growth in the second quarter. On the other hand, inflation has eased considerably over the past couple of months to just 2.8 per cent, which, although still above the 0 to 2 per cent target range, is moving steadily in the right direction.
Consequently, it appears as clear as day that the ECB should act soon on interest rates; but then again some of us have believed that to be the case since June. However, there would appear to have been a subtle change in circumstances over the past month.
The ECB's monthly report last week painted a bleaker picture of economic prospects for the second half of the year. There is now at least some recognition at the ECB that economic growth could fall below potential, and fears about inflation are starting to be downplayed. In the past these fears largely centered around the second-round effects of higher oil prices and euro weakness on wage settlements. The mandarins at the ECB are now scaling these dangers back and there is a clear move under way to set us up for an imminent easing of interest rates.
Another factor that supports this view is the recent performance of the euro. Since early August the euro has appreciated by more than 4 per cent and is more than 9 per cent off the lows of July. This currency appreciation represents an effective tightening of monetary policy at a time when the European economy needs nothing of the sort.
Hence, I for one would be surprised if the ECB fails to deliver good news when it convenes on Thursday. A quarter per cent cut is most probable, but a bigger gesture would be justified and desirable. Failure on the part of the ECB to deliver anything would be correctly greeted with derision by the markets and would represent another own goal.
From the Republic's point of view this is all very important. If demand in Europe and Asia had held up, then the American IT companies operating in this country would have avoided many of the job losses that we have already seen. However, the reality is that the sharp decline in European and Asian demand has proved detrimental to these companies in the Republic.
Unfortunately the ECB has been too tardy in reacting to the deterioration, but better late than never. This is not to suggest for one moment that a half per cent off interest rates would save the European economy, but the effect on confidence would be positive.
Europe does not have the problems of over-investment that the US is grappling with and would be more responsive to lower interest rates. In the Republic, however, the problems in the IT sector are casting a dark pall over the economy and lower interest rates at this juncture would have little domestic impact. The key variable to watch here is the labour market and how that evolves.
Failure on the part of the ECB to seek to arrest the decline in economic activity in its jurisdiction would not be good news for IT companies in the Republic and consequently for the health of the economy. Over to you Wim.
Jim Power is head of investment strategy and chief economist at Friends First Asset Management.
