As the French saying goes, the worst is never for certain.
Pondering the current U.S. economic and market uncertainty, Brian Hilliard, director of economic research at Societe Generale in London, envisions two possible scenarios that might ensue from the financial market turmoil spurred by U.S. subprime lending woes.
The first scenario would be akin to the relatively short-term impact of the fall of hedge fund Long Term Capital Management in 1998; the second would reflect the deeper impact that the bursting of the Nasdaq bubble made in 2001.
Scenario A, the dip in growth is short-lived and monetary policy focus rapidly switches back to inflation. The Federal Reserve cuts rates only two or three times in 2007, which brings the crisis to a quick end, Mr. Hilliard said in an interview. He co-authored a report, Market Shocks.
In the second case, the liquidity effects intensify and there is a significant tightening of credit conditions, which hurts growth badly, said Mr. Hilliard who anticipated that the Fed would then cut the funds rate to as low as 2.5% from 5.25%, while the European Central Bank would lower its key lending rate to 3% from 3.75%.
Of course, U.S. monetary policy would play a major role in the outcome of either scenario. In the milder turn of events, the Fed might cut the funds rate in the coming months to as low as 4.5% but reverse the moves in 2008 as the economy picks up.
In a bleaker context, the Fed does the same, but the situation is not stabilized by these relatively minor moves. The real economy feels a significant impact from the financial market distress and the Fed is forced to continue cutting to as low as 2.5%, the Societe Generale report said.
Mr. Hilliard forecasts that under the first short-term crisis scenario, the U.S. gross domestic product would expand by 2.25% to 2.5% in 2007 and by 2.5% to 3% next year. However, U.S. growth could slump to 2% to 2.25% in 2007 and 1% to 1.5% in 2008 if the crisis lingers.
The depth of the U.S. liquidity crisis would not spill over into foreign economies in 2007 as Societe Generale projects the same growth forecasts under either scenario: 2.5% to 2.75% for the eurozone; 2.75% to 3% for Britain; 11.5% for China; and 2.5% for Japan.
But the impact would widely differ for economic growth abroad in 2008, depending on the short-term or longer term crisis hypotheses: from as high as 2.25% to as low as 0.5% for the eurozone; 2.25% to 0.75% in Britain; 10.5% to 9% in China; and 2% to 0.5% in Japan.
On the currency front, Societe Generale forecast that the milder scenario would be supportive of the U.S. dollar due to flight to quality and despite fed funds rate cuts; the return of the carry trade would weaken the Japanese yen, but not to pre-crisis levels; and the euro would slip as the ECB cuts rates.
However, under the more severe scenario, the U.S. dollar would weaken because of aggressive rate cuts, the yen would weaken along with the Japanese economy and the euro would benefit from comparatively higher interest rates.