Financial turmoil intensifies; broader solutions are sought

The monetary conditions indicator is a composite index based on the Fed funds rate, the 10-year bond yield, the yield curve slope and the effective or trade-weighted dollar exchange rate. Monetary conditions eased over the last week, with their biggest weekly move for some time. This was mainly driven by a significant steepening of the yield curve - reflecting expectations of possible Fed cuts and the heightened demand for shorter-term government paper - and a drop in 10-year yields. Looking ahead, if expectations of renewed monetary easing become entrenched, this may lead to some softening of the dollar, implying an additional loosening of monetary conditions.

Growth forecasts - US, UK & Eurozone

The newsflow from financial markets this week has been arguably more important for global growth prospects than the data releases. The extreme level of risk aversion raised the threat of an even tighter squeeze on credit availability, while steep falls in stock markets risked intensifying negative wealth effects on consumption. With financial markets ending the week on a stronger note, thanks to the announcement of a proposed 'bad bank' which would absorb large quantities of bad assets from the banking sector, these risks have receded for now. However, even if this scheme goes ahead, the evidence still points to the continuation of depressed conditions in the real economy. There were several disappointing data releases this weak, most notably US August industrial output and housing starts and UK unemployment.

Latest data in detail

Industrial output dragged down by slump in car production

Industrial output fell sharply in August, by 1.1% from July and 1.5% from the year-ago level. The decline was caused by a sharp contraction in the production of motor vehicles and parts, which plunged 11.9% and caused manufacturing to fall 1.0%. Excluding this sub-category, the index for manufacturing decreased 0.3%. However, this is little relief, as the crisis in the automotive industry is far from having bottomed out, and it has depressed retail sales, industrial output and the labor market.

CPI falls in August, signalling inflation may have peaked

The CPI for all urban consumers fell 01% in August, after a 0.8% rise in July. This took CPI inflation down to 5.4%, from 5.6% in July. The decline in CPI was helped by a 3.1% decrease in the energy price component. We now expect inflation to fall quite rapidly, due to the combination of lower oil prices and sluggish domestic demand. Core CPI rose 0.2% and was 2.5% higher than a year earlier.

Fed keep rates on hold despite huge strains on financial system

The Federal Reserve kept rates on hold at 2.0%. This outcome, which was taken for granted until the week before the meeting, was not expected by the markets, which had fully priced in a cut in light of the financial stress which led to the collapse of Lehman Brothers. In its statement, the Fed acknowledged both growth and inflation risks, but it also highlighted how 'strains in financial markets have increased significantly'. Our forecast remains for rates to be kept on hold until 2009Q2, when we expect an increase.