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Asian Development Outlook 2006 : I. Developing Asia and the World : Prospects for the World Economy in 2006-2007
Outlook for major economiesUnited StatesThe US economy grew by 3.5% in real terms in 2005, down from 4.2% in 2004. Headline consumer price inflation was 3.4%, while prices exclusive of food and energy rose by 2.2%. Unemployment fell to 5.1% from 5.5% in 2004. Average real hourly earnings fell by 0.4%. Industrial capacity utilization rose by 1.5 percentage points year on year to December, to 81.2%, roughly its long-standing historical average rate from 1972 until now. Despite its robust performance, the US economy did not display signs of significant overheating. Policy interest rate increases (of which there were eight in 2005 and two in the first 3 months of 2006) mark a return to a more "neutral" monetary policy, and reflect the need to guard against energy price increases and strong demand being built into price expectations and wages. Inflationary pressures remain restrained.
The US twin (fiscal and trade) deficits continue to cause concern. The fiscal deficit, exclusive of income on the social security trust fund, fell to 4.0% of GDP, as tax revenues outpaced spending growth, but the US Congressional Budget Office expects the deficit to widen slightly in 2006. The US trade deficit widened to 5.8% of GDP in 2005 from 5.3% in 2004, and continues to expand, reflecting faster growth of domestic spending over domestic output, and low savings. The US savings rate was 14.2% of GDP in nominal terms in 2005, roughly its average level of the past 3 years.
JapanJapan's long-anticipated economic recovery took hold in 2005, strengthening rapidly in recent months. Real GDP grew by 2.7%, up from 2.3% in 2004 (Figure 1.2.2). Investment rebounded in 2005, growing by 4.3%. Providing further comfort, the unemployment rate fell to 4.4% in 2005 from 4.7%, and average real wages rose slightly. Consumer prices fell by 0.3% in 2005, but deflation seems to be coming to an end. In December, prices fell by an annualized rate of 0.1%, and in January 2006 inflation crossed the threshold into positive figures, rising to an annualized 0.5%. The primary fiscal deficit (excluding surpluses on social security funds) is estimated by the Economist Intelligence Unit to have fallen from 4.8% of GDP in 2004 to 4.5% in 2005. The fiscal year 2006/07 budget has been passed, and envisages reduced spending and higher revenues as a result of renewed economic growth. Both these improvements are good news, as Japan's debt-to-GDP ratio was a striking 160% in the fourth quarter of 2005. Meanwhile, monetary policy, which has been extremely supportive of the recovery, is likely to tighten. The Bank of Japan ended its policy of "quantitative easing" in March 2006. The central bank is expected to raise nominal interest rates soon, in order to prevent real interest rates from turning negative as prices rise.
Given the strength of the recovery, a recent pickup in both domestic and external demand, and considerable pent-up consumer spending from the years of deflation, the Japanese economy is expected to grow by 2.9% in 2006. In 2007, as the momentum of the recovery begins to subside, the growth rate is projected to fall to 2.4%, closer to its long run potential growth rate of around 2.0%. The underlying trend rate reflects the maturity of both the economy and its workforce. The baseline forecast includes an end to deflation in Japan. Euro zoneEuro zone GDP grew by only 1.3% in 2005. That said, the euro zone economy continues to produce signals that, while frequently mixed and interrupted, trend slowly positive. However, the contributions to growth of different countries and expenditure components remain in flux, as reflected in Figures 1.2.3 and 1.2.4. The external sector of the euro zone has performed erratically, and growth of consumption remains tentative. Though Spain has been a strong performer, France, Germany, and Italy have seen significant fluctuations, with France and Germany experiencing a slowdown in the last quarter of 2005. The fourth quarter of 2005 saw growth fall to 1% in the euro zone, as consumer and external demand contracted. Continued growth in investment supports cautious optimism. All the major euro zone economies face significant fiscal problems. French, German, and Italian fiscal deficits have persistently exceeded the 3% of GDP targeted by the EU's stability and growth pact. Even with most of the smaller European economies within the target range, the scope for fiscal stimulus to support the recovery is sharply limited. Monetary policy in the EU has tightened a little recently, with the European Central Bank (ECB) raising rates by a quarter percentage point to 2.25% in December. Despite firm handling by the ECB, inflation has slightly exceeded its target of 2% for 6 years in a row. In combination with the persistence of high unemployment in most of the euro zone (Figure 1.2.5), the tendency of the economy to register high inflation while showing disappointing growth reflects serious underlying structural problems. Until these are resolved, a convincing upswing in performance may be delayed. Growth in the euro zone is forecast at 2.1% in 2006, reflecting expectations of somewhat stronger performance in the larger economies, and the related modest growth in investment. Little change is expected in 2007.
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Figure 1.2.1 shows the importance of consumer spending in driving US growth. US consumption growth has, at least until recently, been supported by the wealth effects of rapidly rising house prices. Consumption braked in the fourth quarter of 2005, slowing growth to 1.6% at a seasonally adjusted annualized rate. Rosier recent retail and production figures and tentative improvements in employment growth suggest that the fourth quarter results were a temporary dip, related to Hurricane Katrina. However, on the downside, tightening monetary policy and long-anticipated effects of higher energy prices are probably playing a role as well. The former appears to be contributing to a softening of the housing market, while the latter has crowded out nonenergy consumer spending from 57.5% of gross domestic product (GDP) in the second quarter of 2003 to 55.9% in the fourth quarter of 2005.
The baseline projection is for US real GDP growth of 3.3% in 2006 and 3.1% in 2007. This reflects gradually softening consumer demand as the effects of recent increases in oil prices and interest rates make themselves felt, and an assumption that government spending growth slows. This projection also assumes that policy interest rates will be raised once again in the first half of 2006. Significant downside risks remain if house prices weaken suddenly, oil prices rise much higher, or investor demands for dollar assets change in light of accumulating international imbalances.
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