Calm down, financial markets: the message on UK and US growth is good

http://www.theguardian.com/commentisfree/2014/oct/31/financial-markets-message-us-uk-growth-is-good

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The special relationship between the US and the UK when it comes to foreign policy may be alive and well – but when it comes to monetary policy, our economic indicators aren’t always in step.

While both countries are on the road to recovery, their economies have experienced differing rates of GDP growth, inflation and employment at different periods since the recession hit in 2008. This has had different consequences for them.

The IMF forecasts that UK GDP will have grown by 3.2% this year and 2.7% next year, making it the fastest growing economy among the G7 countries in 2014. However it forecasts American GDP will expand at 2.2% this year, and that it will take the growth baton from the UK with 3.1% growth next year.

On Wednesday the US Federal Reserve ended its third quantitative easing programme (QE3) in a sign that the US economy has recovered. While the Bank of England made its last purchase under its QE programme in July 2012, questions have remained over which country will raise interest rates first.

The argument over which economy would take the lead is a finely balanced one. In the first half of this year it was widely expected that the UK would raise interest rates first, in August or September this year. The UK economy was experiencing a fast pace of GDP growth, beating estimates while rising house prices suggested that the economy could overheat in the short term.

This worried financial markets, suggesting that the pound could become much stronger against the US dollar, making UK firms uncompetitive in global markets. The cost to UK firms selling their goods overseas would increase, making it much harder to export to its key trading markets in Europe – which accounts for more than 50% of exports – and at a time when economic activity in Europe was weakening. In fact, a weaker currency was needed to give a vital shot in the arm for UK exporters. Raising rates before the US also carried the prospect of higher long-term interest rates, which would also lead to slowing economic activity.

However, as we approach the end of 2014, it is no longer a foregone conclusion that the UK will make the first move on interest rates. What’s changed since the beginning of the year?

First, the UK pace of economic growth appears to be easing. The mortgage market is slowing and, crucially, price inflation is now falling back, with no sign that the fall in unemployment is leading to a rise in pay inflation. British manufacturing also slowed in September as demand weakened at home and in Europe.

UK growth is still healthy but it has not kept up the same pace since the start of 2014. Quarterly growth has slowed from 0.9% in Q2 to 0.7% in Q3; whereas US growth seems to have accelerated from a fall of 1% in Q1 to a rise of close to 1% in Q3.

A second clue is the Federal Reserve’s latest forward guidance on interest rates. In some aspects it was the same as previously stated, saying that interest rates would “remain unchanged for a considerable time after the asset purchase program ends” unless “new data indicates faster progress toward the committee’s employment and inflation objectives”.

However, one significant change of language did occur, with the phrase “underutilization of labour resources” being “significant” changed to “gradually diminishing”. The statement went on to point out an improving labour market, with solid job gains and a lower unemployment rate, adding weight to the argument for ending QE. The net effect of this was to make the statement more hawkish, perhaps more than was expected. As a result, markets reacted sharply – the 10-year treasury yield rose and the dollar went up across the board.

It’s also important to note that the lower oil price and stronger US dollar gave the Federal Reserve the chance to sound more dovish on policy – but it chose not to take that opportunity.

This is particularly striking given the sharp market movements in recent weeks, and suggests that the Federal Reserve may feel bond yields have fallen too far. While more detail will emerge when the minutes are published in mid-November, the changes reinforce the impression that the Federal Reserve is on course to start raising interest rates around the middle of next year.

This has eased the pressure on the UK currency and on long-term interest rates, and explains why the pound has fallen in recent weeks. As a result economists have inched closer to the second half of 2015 for when the Bank of England will raise rates.

Whoever goes first, the message on both sides of the Atlantic is that rate rises will be modest and gradual, and on that crucial aspect of rate rises, the US and the UK will remain united and move together.

It is right that the US should end QE with recovery under way as it seems to have served its purpose. The risk is that the rest of the world cannot keep up with the US, and the strength of its recovery starts to widen its trade deficit. As driving global growth is concerned, over the next few years, the US will once again become the indispensable nation.