TIGHTEN YOUR SEATBELTS : 2011 COULD BE WORSE THAN 2010 / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Tighten your seatbelts: 2011 could be worse than 2010


By John Makin

Published: April 11 2011 21:22


As the US moves into the second quarter of 2011, it is tempting to make comparisons with a year ago, just before the double-dip scare in the country pushed down global markets and interest rates. Now, US growth estimates are slipping, the Federal Reserve is talking about an exit strategy and external shocks – the Arab Spring and Japan’s earthquake – have boosted macro-economic risks. Furthermore, US fiscal policy is tightening instead of easing.


In contrast to 2010, which saw extra fiscal stimulus in December, forthcoming public spending cuts will lower growth in 2011. The battle over a possible US government shutdown has already cut $40bn from the 2011 budget, shaving about half a percentage point from midyear annualised growth rates. Momentum on reducing the deficit is building in Washington as Congress and the White House consider reform to benefit entitlements.


And this comes at a time of an external shock in the first quarter of 2011 from a stagflationary rise in oil prices. By most estimates, if the oil price increase since October were sustained, it would take 1 percentage point off growth this and next year.


The difference between this year and last is probably best captured by comparing the Fed’s challenges. In 2010 after a flirtation with the idea of tighter monetary policy, the mid-year growth scare led to a sharp reversal. In 2011, as inflation rises, the Fed faces a far more challenging situation, especially given the slowdown of growth.


While three of the Fed regional presidents who are voting members of the federal open market committee have called for a clearer stance on the move towards an exit strategy, the dovish core, led by the chairman, Ben Bernanke, has rejected that, arguing that inflation expectations remain stable. His apparent reluctance to consider it may be related to the dilemma a central bank faces in an age of stagflationary energy prices and tightening fiscal policy. That said, the forces driving inflation mean demands for a shift are rising.


Rising pressure on the Fed to tighten as inflation increases means that in the event of an oil-shock-induced slowdown, it will not be able to respond promptly. Given the heavy criticism it faced once it launched a second round of quantitative easing (QE2) last year, Mr Bernanke will face dissent on the FOMC and harsh criticism from Congress for risking higher inflation if there is even a hint of QE3.


While most forecasts are still assuming there is leeway for more fiscal stimulus, the presence of a Republican majority in the lower house of Congress has produced a midyear contraction, with more tightening to follow.


Higher oil prices and fiscal tightening make the macro picture more challenging than it was in 2010. Central banks are either tightening (in Europe and most emerging markets) or nervously on hold as in the case of the Fed and the Bank of England. China’s inflation problem appears to be intensifying as its monetary policy is steadily tightened; Japan’s tragic earthquake and nuclear shock mean more supply disruptions in the global economy and a sharp contraction for the country.


Global equity markets have been resilient in the face of these threats, perhaps because the midyear scare in 2010 proved a buying opportunity for risk assets. However, the recovery of risk markets after August 2010 was driven, in part, by aggressive stimulative monetary and fiscal policy measures emanating from the US that will not be repeated in 2011. The best that can be hoped for is a neutral policy from the Fed. Fiscal policy, rather than expansionary, is already on track to be sharply contractionary.


The 2011 combination of a shock from higher oil prices and fewer policy options may lead to more volatile markets than this time last year. Despite rising political and market tensions about US inflation, the lesson of 2010 is that the inflation/growth outlook can change rapidly in a way that quickly leads to calls for more — not less — policy stimulus. Given that fiscal policy is already tightening and scheduled to be tightened further, the Fed would be wise to hold to its accommodative stance for now.


The writer is a resident scholar at the American Enterprise Institute
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Copyright The Financial Times Limited 2011