The current credit crunch is unquestionably more difficult, protracted and dangerous than other recent financial upheavals. The damaging consequences will take a long time to sort out. The crisis has initially hit the debt markets, but share prices weakened sharply in October. At their lowest point, bank shares were down 40% to 50% from their 2007 peaks. The opaque nature of many debt products has made it difficult to quantify the true size of the losses and has fostered an atmosphere of panic and exaggeration.
GDP growth forecasts for 2008 have been cut everywhere as a result of the debt crisis. The downward revision is biggest in the US. But 2008 forecasts are also weaker for the eurozone, UK, Japan and China. Outright recession is still unlikely in most major economies, but threats of a nasty 2008 downturn can no longer be shrugged off.
Rates The Fed has acted early and decisively by cutting its key policy rate in September, from 5.25% to 4.75%, the Fed cut rates again at end-October to 4.50%. The markets expect the Fed to cut rates at least once more early in 2008 to 4.25%, even though further easing entails risks. In Europe the reaction has been slower. Eurozone interest rates at 4% and UK rates at 5.75% have stayed unchanged since the crisis started in August. But policy is set to ease.
The Bank of England’s gloomy inflation report has been interpreted as a clear signal that UK Bank rate will be cut to 5.25% and perhaps 5%, before mid-2008. The European Central Bank has also remained hawkish. But, given the mounting risks posed by the strong euro, we expect two cuts in eurozone rates, to 3.50%, in the next six months.
However, rising inflation is a serious problem. Surges in oil prices to levels above US $90/barrel, and sharp increases in food prices to levels more than 30% above a year ago, pose acute risks: they add to cost pressure, squeeze profit margins and weaken economic growth. The central banks may not be able to cut interest rates aggressively, just when such cuts are most needed. Continued US dollar falls, while needed, accentuate pressures and may unleash dangerous international tensions.
David Kern of Kern Consulting is economic adviser to the British Chambers of Commerce. He was formerly NatWest Group chief economist
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