The reasons are both cyclical and structural. While global industrial growth accelerated once the period of maximum uncertainty ended after the fall of Saddam Hussein's regime, it peaked a year or so later in the spring of 2004 and has been slowing ever since. This cyclical downswing has occurred against an unusual backdrop.

The global recession that began the century brought in its wake a veritable "globalization tsunami," as we described it in our writings more than a year ago - unintended consequences of actions undertaken for entirely different purposes. Nevertheless, it resulted in a wave of deflation in tradable goods and services, which helped keep a lid on inflation in spite of a surge in monetary and fiscal stimulus, especially in the U.S.

An already tight U.S. housing market was supercharged by Fed rate cuts, replacing the wealth effect from the dot-com boom with the wealth effect from soaring home prices. The result was a milder recession, with an industrial downturn largely countered by a resilient U.S. consumer. As the economy recovered from the 2001 recession, and then from the 2002-03 slowdown that ended with the Iraq war, consumer price inflation exhibited cyclical upswings but remained restrained in magnitude, thanks to imported deflation.

In the U.S., the forces of globalization combined with strong productivity growth to check growth in both jobs and wages, boosting corporate profits. The availability of these hoards of cash reduced demand for corporate borrowing, helping to reduce bond yields. Meanwhile, the sharp rise in Asian imports, especially from China, was paid for in dollars that were recycled back in the form of huge purchases of treasury securities, also keeping a lid on interest rates. In combination with falling inflation expectations, the result was unusually low longer-term bond yields, which kept boosting U.S. home prices. Partly as a result of this housing related wealth effect, consumers were able to sustain the spending growth that kept the U.S. economy expanding at a pace close to its long-term trend.

Meanwhile, after months of soaring input prices driven by an accelerating Chinese economy, the global industrial slowdown, which encompassed China as well, has brought overcapacity and thus plunging prices to many inputs like steel. This is being interpreted by the markets as a harbinger of a further slowing in global growth, reducing inflation pressures.

Yet, concerns about limits to the expansion of future supply have pushed oil prices to new records. Ironically, because it is thought to act like a tax on consumers, the rise in these input prices has also been taken to portend a slowing in growth, not a rise in inflation. The resulting worries about a further cyclical slowdown in growth have helped to drive bond yields down even lower.

The silver lining, of course, is that low mortgage rates are likely to keep home prices aloft, and consumer confidence afloat. The likely result is the continuation of a resilient U.S. expansion in the coming months.

The Death of Inflation?

The global industrial slowdown has had a more serious impact on major Eurozone economies, which were already floundering. With strictures relating to monetary union inhibiting both monetary and fiscal stimulus, the largest Eurozone economies like Germany have not experienced the sort of recovery seen in the U.S. The upshot has been much lower bond yields than their U.S. counterparts, but this has done little for the economy.

Bond yields are even lower in Japan, which has spent almost all of the last seven years in deflation. The advent of the current global industrial slowdown extinguished even the first hint of a rise in consumer prices since 1998.

With ten-year government bond yields holding under 4% in most major economies, and well below that in many cases, it is not surprising that yields have stayed low even in economies like the U.S. that are showing steady growth. However, it is important to understand that, to the extent that this drop in interest rates is related to a cyclical slowdown, it is not a long-term condition.

Certainly, ongoing structural changes like globalization have helped to counter inflationary forces in some markets with deflation in other markets, resulting in low overall inflation. But in the last five years, the U.S. economy has spent two thirds of the time in periods of falling growth. Even during the business cycle recovery that began in November 2001, more than half the time has been spent in such periods. This pattern will not necessarily persist.

In any case, the eventual upturn in global industrial growth is likely to negate the key cyclical factor keeping inflation down. If the recent pattern of spending most of the time in growth rate downturns is also broken, that is likely to affect the current complacency reflected in longer-term inflation expectations.

It is true that vigilance about inflation in many central banks, along with major deflationary structural changes, have appropriately damped longer-term inflation expectations. However, from a cyclical viewpoint, the recent experience is neither typical nor permanent, and leaves room for a rise in inflation expectations once the cycle turns.

A Matter of Expectations

The fall in inflation expectations in recent months has occurred in tandem with a plunge in business expectations, as the global industrial slowdown has unfolded. This is clear at least for U.S. and German business expectations which have been trending down. In Japan, business expectations were slightly off their highs as of the first quarter of 2005, and it is possible that they will show a more clear-cut decline once the second quarter data are released.

The pattern is not quite the same as far as consumer expectations are concerned. While they have been trending down for more than a year in the U.S., in line with the moderation in growth, the data for May and June show distinct improvement, underscoring the resilience of the U.S. consumer.

In Japan, consumer expectations have actually improved to their best readings in a decade. While data are available only through the first quarter, other monthly surveys suggest that expectations have not flagged significantly in the second quarter. If this trend persists, the eventual upturn in global industrial growth could bode well for the Japanese economy. Things are not quite as sunny in Germany, where consumer expectations, while above their 2003 low, remain far below the highs seen in 1999 and 2000. Still, consumer expectations are not far from the highs seen during the business cycle recovery that began in 2003.

What is clear is that, despite a global industrial slowdown that has dampened the spirits of businessmen, consumer expectations are holding up even in Germany, while in Japan, they are quite positive. In the U.S., they are improving after a stumble earlier this year. The latest data points in the U.S. and Germany show business expectations ticking up as well.

Thus, while the near-term outlook for industrial growth is still lackluster, there are some positive signs. Most importantly, despite the narrowing of yield spreads and widespread jitters about growth prospects, a recession in a major economy is not likely this year.

Lakshman Achuthan
Managing Director
Economic Cycle Research Institute (ECRI)
+1.212.557.7788, www.businesscycle.com

29 July 2005