Fears of a crisis of a 1930’s type arase following the financial crisis that bursted one year ago, even though the recent credit crisis has little in common with the 1930’s crisis both in its nature and in the reaction of the monetary authorities. After huge liquidity injections, after a widening of the perimeter of Fed’s intervention, both regarding the diversity of the eligible collateral and the institutions that have access to the liquidity facilities, after an investment bank was rescued and massive recapitalization operations took place, fears of the possible materialization of systemic risk receded. No doubt, the financial crisis is not yet entirely over, as abnormal spreads persist in the interbank market and as, for example, monoliners have seen their ratings downgraded. Anyway, the worst has been avoided. However, the impact of the crisis on the real economy has far from fully developed. The cost of funds has increased, credit standards have tightened as testified by the central bank surveys (FED Senior Loans Officers survey, ECB quarterly survey). A strong slowdown in credit distribution to the households sector has taken place. No doubt, that contributes to a moderation in consumption. The decrease in house prices (-15% Y/Y for the main 20 towns in the US according to the Case Schiller index) has put an end to the possibility for households to extract liquidity from their tangible wealth. There again, we have a negative development for internal demand that comes on top of the adverse impact of excess inventories on construction activity. Sure, US growth has been very low (0.6% annualized in 2007 Q4 and 0.9% in 2008Q1), but thanks to a positive contribution of foreign trade (lagged impact of a weaker dollar, contraction in imports resulting from the moderation in domestic demand), the US economy has avoided a much feared recession. The ISM index remains much higher than the levels recorded before previous episodes of recessions (CHART). Following the deterioration of the labour market with job losses for 5 months in a row, and the acceleration in inflation driven by food and energy prices, real incomes have been eroded and households confidence has dropped to historical lows. Nevertheless, the implementation of the fiscal package that was adopted last winter has begun to bear fruits: in May, retail sales increased by 1% (m/m) All in all, the deterioration in activity was less impressive than one could have feared. In euroland, growth (with marked differences between member countries) turned out to be stronger than expected (0.8% Q/Q in Q1 after 0.3% in 2007 Q4). On a Y/Y basis GDP growth (2.2%) was in line with potential. Although, economic indicators point to a slowdown in the coming quarters (the composite PMI suggests a rate of growth of 0.3-0.4% Q/Q), this is far from a collapse in economic activity.

A new guest: inflation Against that back drop, the Fed, even though it mentioned the persistence of downside risks to growth, has announced an end to rate cuts. As for the ECB, it has toughened its anti-inflation rhetoric by announcing the possibility of a rate hike in July. One should not forget that before the bursting of the subprime crisis, the ECB was ready to increase rates above the present 4% level, in order to get back to a neutral stance and inflation was not as elevated as it is today. In fact, the acceleration in prices in a context of an economic slowdown has created fears that we were to experience an episode of stagflation, 1970’s style. As of today, economies are confronted with a relative price shock (food and energy) that has not been followed by an acceleration in underlying inflation. In order to contain inflationary pressures it is crucial to keep inflation expectations well anchored, especially as inflation perceptions are highly sensitive to developments in food and energy prices. When inflation expectations drift up, there is a threat that a wage price spiral could appear which is very costly to eliminate in terms of growth and jobs, as we learnt from the experience in the late 1970’s and early 1980’s. Hence, the recent change in attitude by central banks. Their concern is emphasised in the US by the fact that the expectation of a more accommodative monetary policy is dragging the dollar down which comes with an adverse impact on oil prices. In the case of Europe, the fact that the Phillips curve has flattened (or, to put it differently the fact that inflation had become less responsive to the output gap) would make the fight against well rooted inflation even more costly), good reasons for the central banks not to remain “behind the curve” and protect their credibility. This attitude should eliminate the likelihood of a 1970’s style scenario.  The situation in many emerging countries is very different. In some cases, the objective to keep exports as  an engine of growth results in keeping exchange rate targets that contribute to inflate domestic liquidity that feed inflationary pressures and import prices. In cases  when increases in rates are decided they are too limited to result in positive real rates. Hence, the incentives to increase debt remain in place, demand is boosted so are energy and food prices. On top of this, demand is artificially boosted by public interventions (caps on prices, subsidies..) that aim at “protecting the consumer” but result in higher demand for energy. Only resulting pressure on public finances seems able to put an end to these practices.

D'Arvisenet editorial reflects the view of the Economic Research Department of BNP Paribas. It is published for information purposes only. Neither the information nor the opinion expressed constitutes an offer or solicitation to buy or sell any investments. Information contained herein has been obtained from sources believed to be reliable but BNP Paribas does not guarantee its accuracy or completeness. All opinions and forecasts are subject to change. Discretion with respect to suitability should be prudently exercised.