The Group of 20 meeting in Mexico rightly tackled the eurozone as the biggest threat to the world economy and financial system (and supported Prime Minister Julia Gillard’s comments). But the talk fest missed the other big global concern — the stuttering US economy and frozen political system that could prove to be the crisis of 2013. It will be a much tougher issue to tackle in the next year than Europe.

While Europe remains a huge concern, as the latest deal to try and steady Spain and Italy attests, the American economy is slowing, debt and deficits are larger than Europe as a whole, there’s a spending/debt brawl ahead that dwarfs the one we saw in August last year, and the November elections will likely convince no one. As a result, the US Federal Reserve, concerned about the slowdown in the economy and unemployment, “twisted” again overnight. In doing so it cut its economic forecasts, sending markets lower and raised the prospect the US economy will get more assistance if needed.

The US Federal Reserve warned that “strains in global financial markets continue to pose significant downside risks to the economic outlook”, a direct reference to the continuing problems of Europe. The central bank cut its growth forecasts for the US for this year, left its current interest rate forecast unchanged (no change until at least 2014) and raised its jobless forecast in a move that shocked markets.

“The Fed is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labour market conditions,” the central bank said in what amounts to adopting an easing bias.

The downgrading in the growth estimates took markets by surprise and knocked Wall Street lower on the day. Gold and oil also dropped. That was after a strong day in Europe following confirmation that the eurozone’s two support funds would be used to buy up to €600 billion of Spanish and Italian bonds in an effort to steady markets and drive bond yields lower. The Australian dollar remained close to $US1.02 in trading this morning.

Spain and Italy’s bond yields eased as the news of their bailout became more certain and not just another EU kite. Yields on Spain’s 10-year bond yields were down 14 basis points to 6.8%, after falling below the symbolic 7% barrier. Italian bonds fell 0.10% to 5.79%. In Greece, New Democracy, the PanHellenic Socialist Movement and the Democratic Left splinter group, formed the new government. The three parties won 179 seats in the 300-member parliament. Having risen 22.6% in a week Tuesday, the main Athens share index was almost flat on Wednesday.

Early this morning in Washington, the Fed took another unconventional step to boost the economy by extending its so-called Operation Twist, where the central bank sells short-dated bonds and buys the same amount of longer-maturity securities. This time it’s another $US267 billion with the aim at reducing borrowing costs, especially for mortgages. The existing program was due to expire at the end of this month and has bought nearly $US400 billion. US rates have fallen, but that is as much due to investors around the world looking for safe havens in US sovereign bonds as Europe’s woes have worsened than the Fed’s “twisting”.

Markets wanted more spending via a third round of quantitative easing, so they fell when it didn’t happen. The Fed suggested that’s a future possibility (and the extra “twisting” was a short-term move) given the way it scaled back its view of the US economy. Growth for 2012 is now forecast in a range of 1.9% to 2.4%, down from 2.4% to 2.9% in March (all annual rates). The new range compares with the 1.9% rate in the first quarter, so the Fed now sees little growth for the US over the rest of 2012. Compare the latest forecast to the one made in April 2011, when the Fed saw 2012 US growth in the range of 3.5% and 4.2%.

No wonder the Fed sees no real change in the most troubling problem for the US: high unemployment. The Fed said unemployment was now projected to be in a narrow range of 8-8.2%, meaning no significant change from the 8.2% in May. In fact, the latest unemployment forecast is an increase from the previous range of 7.8% to 8%. Inflation could fall to a low of 1.7% in the coming year, which is under the Fed’s 2% target and getting close to a level where deflation could be a chance if the economy slows further.

And Fed chairman Ben Bernanke told reporters at his subsequent press conference that he was watching the labour market closely: “We still do have considerable scope to do more and we are prepared to do more. If we’re not seeing sustained improvement in the labor market that would require additional action.In its post-meeting statement, the Fed said that consumer spending has slowed, adding that it expected economic growth to pick up “very gradually”. “Consequently, the Fed anticipates that the unemployment rate will decline only slowly,” the statement said. The Fed also noted that housing remained depressed, despite a rise in building permits and new home starts.

In their usual self-absorbed way, US markets forget Europe after the Fed statement and press conference from Bernanke and the new government in Greece and confirmation that struggling Spain and Italy will be supported were ignored. The news that the European Financial Stability Fund (EFSF) and European Stability Mechanism (ESM) will be used to support Spanish and Italian government debt was good news. But is it going to be big enough? Europe’s problems have always been the difference between the reality of a policy move being weaker than the original announcement.

At the moment, the ESM fund does not yet exist. It has not been ratified by Germany and Italy. When it does come into being, it won’t have much money. It has a theoretical limit of €500 billion — a nice wish — but its paid up capital will start at just €22 billion.  The EFSF has around €240 billion left. The European Central Bank previously bought about €210 billion of sovereign bonds in this way but stopped last year (mostly Greek, Italian, Spanish, Portuguese and Irish government debt).

For the time being the combination of the new Greek government and the emerging support structure for Spanish and Italian debt should steady jittery markets, while the Fed’s latest move will continue to assure markets that the sluggish US economy is not being obscured by Europe’s pressures. But later this year and in early 2013, the US will become the focus of global nerves. The congressional and presidential polls, the impasse between the Democrats and Republicans over spending and debt, and huge automatic cuts in spending due to be triggered next year, will all come together to make America the new eurozone.

Another crisis in Greece or Spain will accelerate the concerns about the US.

For all the talk of a new “Lehman” situation in Europe, America has the capacity to provide the biggest negative shock to the world economy in the next year if things go badly. The cuts to spending could plunge the US into a sudden and nasty recession by this time next year. With Europe still weak, China sluggish and other economies under pressure, that could return the global economy to the depths of the 2008-09 GFC.

Peter Fray

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