Ward: Is the global economy about to 'double dip'?

Henderson chief economist Simon Ward questions whether monetary tightening and fiscal cutbacks could send the global economy into a ‘double dip’ recession.

Recent economic news has been unexceptional, but the balance of surprises has turned negative, consistent with a slowdown. Investors, however, are concerned that emerging weakness marks the beginning of a "double dip" rather than a short-term resting phase.

Such worries, of course, have been exacerbated by the eurozone sovereign debt/banking crisis and associated falls in markets, as well as growing awareness of coming fiscal austerity.

The evidence to date, however, provides insufficient basis for altering the view that a slowdown, albeit sharp and possibly extending until early 2011, remains more likely than a second recession.

A key element in this judgement is that G7 real M1 continues to expand, with the six-month rate of increase stabilising recently - see chart. The six-month change, by contrast, fell to zero before the mild 2001 global downturn and turned negative before the 2008-09 slump.

Real money expansion, moreover, remains strong in emerging economies, slowing by much less than in the G7, even in countries - such as China - where policy has tightened.

Softer global economic growth should push back further restriction and ensure that monetary conditions continue to underpin domestic spending, with associated import demand offering support to activity in developed economies.

A further barrier to a second recession is strong G7 corporate cash flow and liquidity, arguing against significant new cuts in capital spending and jobs.

G7 fixed investment, expressed at constant prices, is the smallest proportion of GDP for at least 50 years while stock levels remain low relative to current production. US firms slashed employment particularly aggressively during the recession, implying less need to economise now should growth disappoint.

Could fiscal tightening produce a 'double dip'? The possibility cannot be discounted but there is little evidence of a consistent impact of G7 fiscal changes on short-term growth outturns in recent decades.

Fiscal restriction, moreover, is an issue for 2011 and beyond rather than an explanation for the current slowdown: the G7 'structural' fiscal deficit is forecast by the Organisation for Economic Co-operation and Development (OECD) to widen slightly this year.

Some commentators argue that emerging economic weakness, even if it falls short of contraction, will result in deflation. This seems unlikely.

G7 core inflation showed only a limited response to the worst recession since the Second World War so it would be surprising if a much less severe downturn triggered a major pricing shift. (As an aside, US core consumer price inflation would be significantly higher if calculated using European methodology, which omits imputed rents.)

The slowdown, indeed, could increase the chances of higher inflation over the medium term, to the extent that it prolongs monetary excess in emerging economies and particularly if it supplies a pretext for the Federal Reserve to resume "quantitative easing" (QE).

Whilst QE may be extended by the Fed in pursuit of a weaker dollar it is also likely to be welcomed by the Obama administration ahead of important mid-term elections in November.