Deteriorating prospects for the US consumer and a deeper and more prolonged than expected slump in the US housing market lie at the heart of the weaker global outlook. Fitch now expects rising income uncertainty and falling asset prices to contribute to broader retrenchment by the US household sector in the form of a rise in the saving ratio. Strong policy stimulus, resilient business investment and buoyant exports will limit the severity of the recession, but US domestic demand growth will be weaker than in 2001.
Given the importance of US consumers as a source of final demand for the rest of the world in the current decade, this will undoubtedly have sizeable knock-on effects elsewhere through trade linkages, including in emerging markets. But housing and consumer spending adjustments are also starting to get underway in other large economies, including the UK and Spain.
Moreover, the persistence of stress in global credit markets increases the prospect that widespread deterioration in credit conditions will take a macroeconomic toll by restraining lending to the real economy. With the bulk of the losses on US subprime mortgage loans being absorbed by financial institutions in the MAEs, banks' recognition of losses on their capital accounts, combined with the lack of stability in investor confidence and loss of investor appetite for most bank unsecured debt as well as asset-backed debt, has resulted in some unanticipated expansion of bank balance sheets.
In the context of desired de-leveraging and rising risk aversion, banks' willingness to lend has fallen sharply. While the evidence is still tentative on the macroeconomic fall-out from the credit crunch - credit growth has actually remained quite robust to date in the MAEs - what has become much clearer is the deterioration in consumer confidence. In the US, UK, France and Spain, confidence is now at its lowest level since at least the early to mid-1990s, pointing to concerns about the outlook for income and jobs.
The ability of policymakers to offset this shock is being constrained to various degrees by recent increases in inflation related to a surge in global energy prices since late last year and high rates of world food price growth. Fitch predicts inflation in the MAEs to average just under 3% in 2008, which would be the highest rate since 1992, while global CPI inflation (weighted using GDP at market exchange rates) is projected at 3.7%, the highest since 1999.
The rise in inflation is giving pause to some central banks in the MAEs where the slowdown in growth is not yet self-evident. However, as weaker activity manifests itself more firmly through the course of the year, Fitch expects further significant cuts in rates, including by the Federal Reserve, BOE and the ECB. Emerging markets are a different story - stronger growth dynamics and larger and more lasting effects from food and energy price shocks are creating an imperative to tighten policy to avoid inflation having more damaging effects on economic performance in the medium term.
