The Real Economy: Output, GDP, and Inflation

Optimism about stabilization in the global economy gained ground over the past two months. Manufacturing and consumer survey indices reinforced earlier improvements, equities surged 39 percent since early March, the pace of output contraction slowed, and signs of stabilization emerged in the housing sector. However, soaring unemployment rates, rising commodity prices, and surging government bond yields pose risks to recovery.

Consumer and business surveys experienced hefty gains in April and May, spurring optimism that the worst of the recession might be over. The U.S. Conference Board’s Consumer Confidence Index climbed to an eight-month high of 54.9 in April, up from just 26.9 in March and 39.2 in April. Improving consumer confidence, coupled with significant gains in the stock market, has lifted the Conference Board’s Leading Economic Indicator (LEI) indicator by 1 percent in April, for the first time in a year. Gains in business climate and consumer confidence indices strengthened optimism for economic recovery in euro-zone. The euro-zone economic sentiment index rose to a six-month high of 69.3 in May from 67.2 in April. The German IFO institute’s Business Climate Index increased to 84.2 from 83.7 in April.

Further, the pace of contraction of activity has been slowing down, as the Purchasing Manager’s Index (PMI) has improved significantly across many countries. The U.S. Institute of Supply Management’s PMI rose to 42.8 in May from 40.1 in April, the UK’s PMI index climbed to 45.4 from 43.1 in the previous month, and euro-zone’s PMI jumped to its highest level in eight months in May to 40.5, up from 36.6 in April. Manufacturing activity has even been expanding in some countries; China’s PMI was above 50 for three consecutive months and stood at 53.1 in May, while India’s rose to 55.7 in May from April’s 53.3.

Optimism about stabilization in the global economy has gained ground.  However, soaring unemployment rates, rising commodity prices, and surging government bond yields pose risks to recovery.

Some signs of stabilization in the housing sector have emerged in the past few weeks. Near record-low mortgage rates, combined with tax credits for first-time buyers and significantly lower prices, have helped to stabilize conditions. U.S. new home sales increased by 0.3 percent in April (m/m) to an annual rate of 352,000, while purchases of existing homes rose by 2.9 percent in the same month. UK home values rose 2.6 percent in April from the previous month to an average of 158,565 pounds ($260,000). However, housing starts fell by 12.5 percent over this period.

Retail sales in the United States, the UK, and the euro-zone have posted modest gains. U.S. sales grew slightly in May, up 0.5 percent from the previous month. Euro-zone retail sales increased by 0.2 percent in April from the previous month. Some evidence suggested that layoffs are slowing. U.S. job cuts in May were at 345,000 jobs, down from 504,000 jobs in April and nearly half of the monthly average of the prior six months. Initial jobless claims declined to 601,000 from 674,000 two months ago. Nevertheless, unemployment rate is soaring. It has shot up to 9.4 percent in the United States, 9.2 percent in the euro-zone, and 7.1 percent in the UK.

The rate of contraction in manufacturing has slowed down over the last couple of months; manufacturing has even picked up in some countries. U.S. industrial production contracted by 0.5 percent (m/m) in April, its slowest pace in more than six months. In the UK, manufacturing output declined 0.1 percent in the same month (m/m). In contrast, industrial activity is in a recovery mode in Asia. Japan’s industrial production surged 5.2 percent in April from March, the largest increase in 56 years. In Korea, output rose by 2.6 percent from March, its fourth consecutive month of increases.

Unlike the recent rise in confidence and manufacturing surveys, GDP in major economies fell dramatically in the first quarter of 2009. First quarter GDP fell by a 5.7 percent annualized pace in the United States, 15.4 percent annualized rate in Japan and 3.8 percent (q/q) in Germany. Euro-zone GDP shrank 2.5 percent (q/q), the largest quarterly decline since comparable records began in 1970. Not all nations recorded a fall in GDP. Indian first-quarter GDP grew by 5.8 percent (y/y), while China grew 6.1 percent in the same quarter. Australia registered a positive growth rate of 0.4 percent (q/q) in the first quarter, narrowly avoiding two quarters of contraction.

Economic Policy

Major central banks around the world left interest rates unchanged last month, amid growing evidence that the worst of the recession may be over.

The European Central Bank (ECB) kept interest rates unchanged at 1 percent, after lowering its refinance rate by a quarter in May. The rate has fallen by 325 basis points since October. The bank is also unlikely to expand its asset-purchase program in the short term. The Bank of England held interest rates at 0.5 percent for third month in a row, though it remained committed to continuing with its £125 billion asset-purchase program. In Asia, the Bank of Japan kept interest rates unchanged at 0.1 percent. It did not announce plans to expand the quantitative easing program, despite some signs of growing deflationary pressures. Pointing to positive signs in their economies, Australia, South Korea, Malaysia, Israel, Hungary, and New Zealand also left interest rates unchanged. The U.S. Federal Reserve has kept a key interest rate unchanged at a record low of between zero and 0.25 percent to support the struggling economy.

Other major banks continued to cut their interest rates. Russia cut interest rates for the third time in six weeks to 11.5 percent. Iceland’s central bank lowered the benchmark interest rate by a percentage point. The Norwegian central bank cut interest rates by half a point to 1.5 percent.

Major central banks around the world left interest rates unchanged last month, amid growing evidence that the worst of the recession may be over.

Hong Kong announced additional fiscal stimulus measures valued at $2.2 billion to stem the economic downturn. The initiatives include tax cuts and further relief from a variety of government fees, along with additional direct spending.

In other developments in the last two months, the U.S. Congress passed a $3.5 trillion budget outline for 2010. The budget would set up special funds to pay for sweeping changes in health care, energy, and education. The government said the plan would cut the federal deficit—which is projected to total $1.2 trillion in fiscal year 2010—by more than half in five years.

In another news, the U.S. Treasury allowed ten financial groups to repay a combined $68 billion that came from the troubled asset relief program (TARP) launched last year. The first batch of TARP repayers includes eight banks that last month were found not to need additional capital after government stress tests.

Financial Markets

Global equity markets have been rebounding since mid-March, restoring some of the wealth that had been lost. The rally was boosted by better-than-expected U.S. unemployment figures and banks’ stress test results, increases in global consumer and manufacturing surveys, and some signs of stabilization in the housing sector.

The Dow, the NASDAQ, and S&P jumped by 7.1 percent, 8.1 percent, and 7.8 percent since early May, respectively. They are now up by 30.1 percent, 40.5 percent, and 35 percent since early March. However, equities are still more than 35 percent lower than their late-2007 peak.

In Europe, the FTSE rose by 4.7 percent in the last six weeks. The German DAX enjoyed a good performance, gaining 6.3 percent in the same period. Major Asian indices saw solid gains over the period, with the Nikkei and Hang Seng climbing 13 percent and 22 percent, respectively.

Emerging markets have seen widespread large gains in the stock markets, helped by significantly easing financial conditions. The MSCI EM Index continued to perform well, bringing its total gains for this year to 36 percent and reaching an eight-month high toward the end of May.

Global equity markets have been rebounding since mid-March, restoring some of the wealth that had been lost.

Government bond yields are soaring around the world, amid concerns about inflation, rising government debt levels, and improving risk appetite. Ten-year U.S. and UK bond yields are both close to 4 percent, having started the year at 2.22 percent and 3.01 percent respectively.  U.S. 30-year mortgage coupons are now over 5 percent, having surged from 3.90 percent over the past month, raising corporate borrowing rates. Japan 10-year bond yields have jumped nearly 12 basis points since early May. These yield increase have occurred despite major central banks’ efforts to purchase government bonds and other fixed-income securities. The surge could hamper recovery in lending and in property markets.

In the credit market, the three-month dollar Libor rate fell more than 50 basis points in the last two months on signs that credit conditions are easing. The LIBOR has now fallen about 350 basis points since last October, while the LIBOR-OIS spread narrowed by 280 basis points.
 
In currency markets, the U.S. dollar depreciated against its main counterparts, with the key exception of the yen. The dollar lost 10.5 percent and 15 percent of its value against the euro and pound in the past three months. The pound is nearly 14 percent higher than where it started the year against major currencies. Emerging market currencies appreciated in line with stronger performance of equities and lower volatility.