WEEKEND ECONOMIST: Uncharted territory
Previous recessions point to a cycle of up to three years. This time the sequence of events is different which means that previously established time lines for recovery cannot be relied upon.
Indeed we do not expect another move from the Bank until August when we expect them to resume easing with the objective of bringing rates down by a further 125bps. The first move in the new cycle could easily be 50bps. That forecast differs significantly from current market pricing in a number of respects.
Firstly the market is expecting a 25bp cut next week. Secondly the market is expecting that the easing cycle will be completed by August/September and thirdly it is only looking for a further 50 to 75bps in easing. By predicting no move until August and a larger total move we diverge from market pricing on all counts. In this week’s note we ponder the profile of a recession/recovery.
Previous recessions point to a cycle of up to three years. The events which precipitate recession are usually associated with central banks pushing interest rates too far and/or global developments. The current episode is no different. We look to the RBA’s high interest rate policy in 2007 and early 2008 combined with the shocks to household wealth; credit availability and confidence associated with the global financial crisis.
In the first year of the cycle GDP contracts as consumers slash their spending on cyclical items such as autos and household goods. Housing construction tumbles and consumer concerns about job security soar. Businesses detect this contraction in consumer activity and are usually also unnerved by high interest rates and global economic conditions. Accordingly they slow investment and cut production and inventories. Unemployment starts to rise and the authorities respond with lower interest rates and expansionary fiscal policy.
By the second year the contraction in GDP is curtailed; the monetary and fiscal stimulus starts to take hold; consumers who have kept their jobs start to raise spending on cyclicals and housing; and the world economy begins to recover. However, job losses continue and businesses are still cutting investment. Economic growth, while positive, remains sluggish in the second year.
The second year is also marked by weakening labour income as unemployment continues to rise and falling profits as the sales slowdown hits corporate bottom lines. By the end of the second year the economy is still responding to the economic stimulus; the global economy is well into its upswing; confidence has returned and recovery in spending on cyclicals and housing gathers momentum. Unemployment stabilises.
The third year is marked by above trend growth. Labour income growth gathers pace; consumers boost spending on non-cyclical items and businesses boost investment and production. Central banks prepare to withdraw some stimulus.
At present we are around the middle of the "first” year of this recession cycle. Non-farm GDP started to contract in Q3 2008 and we expect it to continue to fall in H1 2009. Unemployment expectations (our measure of Job Security) are at record lows; spending on cyclicals has collapsed and we expect residential investment to contract by 15 per cent in the first half of 2009. Business investment has slowed and all lead indicators are pointing to a sharp contraction through 2009. The authorities have responded with aggressive fiscal and monetary policy stimulus.
If this current recession evolves as described above there is a strong case for the RBA’s current pause to actually herald the low point in rates. However we expect that the risks around the normal evolution of the recession are much greater than in the past. Firstly the "second” year of the cycle has, previously, been in an environment of positive world growth whereas recent forecasts from the OECD point to world growth continuing to weaken through at least H2 2009.
Our forecasts are for the sharp contraction we have recently seen in global growth and particularly the advanced economies to probably stabilise through the second half of 2009 but we are certainly not anticipating the typical strong recovery in world growth that has marked the second year of previous recessions.
This global recession is deeper than any previous recessions; has been precipitated by a financial crisis and is likely to persist for much longer than previous global recessions. While equity markets have recently recovered somewhat, the improvement in credit markets and credit spreads has been modest at best and we remain deeply suspicious of these early recovery signs.
From a domestic perspective there are complications likely to constrain the normal household spending recovery that would be associated with the second year of the cycle. First, we have seen an unprecedented 10 per cent reduction in household wealth which has been the direct result of the global crisis; second we have seen an extraordinary surge in household savings as households focus on repairing balance sheets and lowering debt.
Finally, we believe that while recessions are always characterised by tighter credit, 2009 is likely to be a year where credit availability is much more constrained than usual due to difficult funding conditions in global capital markets.
For example, we saw a 50 per cent contraction in building approvals for apartments last year which points to greater than normal difficulty in rebooting the residential construction cycle. For these reasons we expect that the RBA has more work to do but is likely to give it the benefit of the doubt for a few more months to test whether the "normal” recovery profile unfolds. We know that the RBA is nervous with rates down even at current levels and decisions to go even lower from here will not be taken lightly.
The task is likely to be centred around the second half of 2009 when it becomes abundantly clear that the typical recovery in the second year of the cycle is not forthcoming – the global economy will fail to rebound; domestic spending including housing and consumer cyclicals will not recover as usual. But for now the RBA is likely to extend its pause until these issues become clearer.
Markets are currently pricing in a modest "tail” of 50 to 75bps to the current easing cycle to play out over the next three months or so. We expect to see an extended pause of almost six months to be followed by a 125bp cycle which will extend through to the end of 2009.
That second easing cycle will be required to supplement continued expansionary fiscal policy to support recovery in domestic spending in the face of the current unusual and dangerous headwinds associated with the global crisis.
Bill Evans is Westpac's global head of economics