Catalog

Prospects for the world economy in 2007 and 2008

Outlook for the major economies

United States

The United States (US) economy grew by a solid 3.3% in 2006, reflecting an upturn in business investment and robust private consumption (Figure 1.2.1). However, quarterly GDP figures demonstrated a visible slowdown in the second half and the year ended on a less positive note. The weak spot was mainly associated with housing sector retrenchment. Residential investment contracted for five consecutive quarters from the last quarter of 2005, and both new and existing home sales fell significantly in the latter half of 2006. Although home sales are showing signs of stabilizing, housing starts and permits continue to slide (Figure 1.2.2), reflecting an excess supply of unsold homes. With falling house prices, these indicators suggest that expectations of an early resolution to the housing-induced slowdown are premature.

Several factors stopped the economy from going into a steep slide. Personal consumption expenditure remained buoyant and grew by 3.2% in 2006, underpinned by relatively healthy job gains and rising incomes. Household discretionary income was boosted by falling oil prices and easing inflation. Solid business investment in several quarters, on the back of strong corporate profits, was another factor.

But there are signs that the housing market trouble is spilling over into both the real economy and the financial market. Industrial production figures are slipping, with manufacturing activity slowing sharply in the last quarter. Falling orders for cars, household appliances, and construction materials could generate ripple effects. All of these added up to a contraction in business investment in the fourth quarter. The emergence of marked increases in payments delays on subprime mortgage loans since late February revealed further elements of weakness.

A pause in monetary tightening since last June has turned into a hiatus. Consumer price inflation has been ebbing, partly in reflection of the tightening, but also thanks to sharp declines in gasoline prices since the fall of 2006. Given the lessened pressure from inflation, combined with slowing economic activity, futures markets expect that the Federal Reserve may start to cut interest rates in the second half of this year. On the fiscal side, strong revenue increases reduced the 2006 US budget deficit for the second year in a row. The Congressional Budget Office projects the deficit to decline over the next 2 years.

The ongoing slowdown in US growth is expected to be moderate. The economy is projected to expand by still a respectable rate of 2.5% in 2007, followed by a quick recovery in 2008. Sustained income growth and low inflation will continue to underpin private consumption growth. A relatively benign business outlook is predicted, based on good corporate earnings and firm demand. While exports are seen maintaining recent gains, robust consumer spending will likely rekindle growth in imports this year. The current account is expected to deteriorate further, though the pace of growth in the trade deficit has stabilized.

Japan

The Japanese economy continues a moderate but steady recovery, registering 2.2% growth in 2006 (Figure 1.2.3). Although the latest revisions (February 2007) reveal less than expected strength of domestic demand, it does not alter the underlying sweep. Strong exports and export-induced business investment are underpinning the recovery, since private consumption is trudging along only slowly. Exports rose by 9.5%, contributing 1.4 percentage points to growth. The pace of private consumption visibly weakened in 2006, posting only 0.9% growth. Stagnating labor market conditions and flattened wage growth contributed to a retrenchment in consumer spending, although a strong rebound in the final quarter was encouraging.

Industrial production rose substantially, pushing capacity utilization higher. Corporate profits set yet another record, offering strong impetus to business spending. Meanwhile, firms have remained cautious in both investment and hiring decisions. Despite the improved industrial activity and job conditions of the past few years, unemployment has stayed relatively high at 4.1%, reflecting firms' reluctance to hire. This picture should brighten over the forecast period, but not markedly given heightened labor productivity and continued corporate efforts to contain rising input costs. Further out, strong corporate profits and tight capacity should eventually exert a positive influence on the job market.

The Bank of Japan raised policy rates by another quarter point in February 2007, the second step since July 2006 in its intended move to a neutral policy stance. However, the slow pace of consumption recovery combined with weak inflation suggests little likelihood of the central bank acting aggressively, and it will probably leave the policy rate at under 1% for most of this year. Consumer price inflation barely made it into positive territory (Figure 1.2.4). If the yen strengthens and oil prices continue to fall, deflation could become a problem again.

The Japanese economy is expected to continue its modest recovery. Projected growth is 2.0% in 2007 on the ground of gradually strengthening domestic demand. Record export earnings should underpin the expansion in business capital spending, while strengthening the job market. The key to sustaining the recovery lies with consumers spending more. The country's aging demographic profile and related high pension burden continue to be a significant drag. Moreover, weakness in the domestic sector could persist, if the inevitable ending of macroeconomic stimuli over the medium term weighs down on consumer sentiment.

Euro zone

A steady recovery is under way in the euro zone, which grew by 2.6% in 2006 on strong exports and firming domestic demand (Figure 1.2.5). Despite the sustained strength of the euro, exports surged by 8.4%. This boosted industrial production across the zone, particularly in Germany, Italy, and Spain. Business and consumer sentiment has improved (Figure 1.2.6). Strong corporate profits and cheap credit bolstered capital spending. This upward trend in turn exerted a positive influence on consumer spending, underpropping sound and balanced growth. Unemployment rates have trended down, and are now firmly under 8%.

A major downside risk is how consumers will react to tax increases. Long-term fiscal sustainability is a significant concern for the euro zone. The major economies of France, Germany, and Italy, have persistently exceeded the fiscal deficit ceiling of the stability and growth pact (3% of GDP). These economies have announced fiscal consolidation plans, combined with significant tax hikes. In both Germany and Italy, fiscal tightening is taking effect in 2007, amounting to an estimated 1% of GDP. So far, consumers appear to be relatively unswayed and their upbeat sentiment remains intact.

Although pressure is easing with falling oil prices, inflation stayed slightly above the European Central Bank (ECB) target rate of 2% in 2006. With the latest rise in March 2007 having lifted the policy rate to 3.75%, continued compression in interest rate differentials has strengthened the euro. While this curbs inflation, it may start to pinch exports. Given the improved growth outlook, ECB is expected to adopt a neutral stance after one more rate increase, perhaps in the middle of the year.

The euro zone is expected to grow by 2.2% in 2007. Prospects for exports and related business investment, as well as consumer spending, are positive. The investment outlook seems set to stay firm, reflecting the strength of corporate balance sheets and tight manufacturing capacity. A modest deceleration in world growth is not likely to seriously undermine performance of the external sector.