Comment: Honeymoon over as markets spurn Obama advances

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The financial markets remain torn by conflicting fears of an immediate slump, unsustainable debt burden and future inflation. Deflation is a short-term risk. In 2009, the US will experience its first full-year fall in consumer prices for more than 50 years.

But the markets are also worried that massive injections of stimulus and increased borrowing will eventually unleash higher inflation. The pervasive mood is one of gloom, driven by fears of deepening recession. As in Japan’s “lost decade”, a deep banking crisis remains the critical obstacle.

Employment
US jobs fell by almost 600,000 in January, the biggest fall in 34 years and the third month in a row of declines exceeding half a million. The jobless rate rose to its highest level since 1992. US job losses since the beginning of the current recession now total 3.6 million and are set to worsen in 2009.

House prices are falling at their steepest pace on record. The 1% rise in US January retail sales was a surprising piece of good news, but the markets have shrugged it off in the face of an avalanche of poor figures.

Europe’s downturn is steeper than in the US. Eurozone GDP plunged 1.5% in the fourth quarter of 2008, the same decline as in the UK, but more than the 1% fall in the US.

Germany, with its heavy exports dependence, has been particularly badly hit by the global recession. Its economy dropped 2.1%, the steepest fall since reunification in 1990.

Rates
The European Central Bank persists with its obstinate stance and has kept its key rate at 2%. While rate cuts are now almost certain, policy remains too tight. In the UK, Bank Rate was cut to 1% and further cuts to 0.5% are likely. But sterling’s weakness exposes the UK to serious risks.

In the US, the Federal Reserve says it will keep its key rate at almost zero for a considerable time. But policy must now focus on quantitative and credit easing, which requires close cooperation between the Fed and the Treasury. The Fed has led the way with aggressive interest rate cuts and is more determined than Europe to boost the money supply by purchasing government bonds.

But negative reaction to the Obama banking package is because of US ideological reluctance to take measures that entail any bank nationalisation. To avoid negative global consequences, a more flexible US line is needed that absorbs the lessons of Japan. Without sorting out the banks, there will be no recovery.

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