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...in oil prices to new highs have highlighted downside risks as the global economy enters the fourth year of this current expansion. Other notable sources of uncertainty include the threat of an abrupt slowdown in the U.S. housing market; lingering doubts about prospects for growth in the other advanced economies; and questions about the resilience of emerging market countries in a more challenging global environment. Moreover, large global imbalances continue to prompt concerns, while the potential for protectionist pressures has increased now that the Doha Round seems to be deadlocked. Against this background, policymakers will need to respond flexibly to events and act with foresight to head off potential strains, recognizing the importance of spillovers across countries and the benefits of taking a joint approach to managing global risks and promoting a robust world economy.
[FIGURE 1.1 OMITTED]
Global Economic Environment
The global expansion was broad-based in the first half of 2006, with activity in most regions meeting or exceeding expectations, and recent indicators suggest that the pace of expansion is being maintained in the third quarter (Figure 1.2). Growth was particularly strong in the United States in the first quarter, although it slowed in the second quarter in the face of headwinds from a cooling housing market and rising fuel costs. The expansion gathered momentum in the euro area, notwithstanding a slow start to the year in Germany, and the Japanese economy continued to expand. Growth in China has accelerated even further, emerging Asia and Europe have continued to grow rapidly, and the pace of activity has picked up in Latin America. Middle Eastern oil exporters and low income countries in Africa have also maintained impressive growth rates.
[FIGURE 1.2 OMITTED]
Sustained high rates of global growth have absorbed spare capacity and led to some emerging signs of inflationary pressures. While estimates of potential GDP are always subject to uncertainty, output gaps seem to be closing in much of the world (Figure 1.3), while buoyant demand for fuel and raw materials has contributed to record high prices for oil and other commodities. Headline inflation in many of the major advanced economies has for some time been above central bank comfort zones, pushed up by rising oil prices, but there are now signs of increases in core inflation, in market-based and survey measures of inflation expectations, and in unit labor costs, particularly in the United States (Figure 1.4). In emerging markets, a number of countries--including Argentina, India, Russia, South Africa, Turkey, and Venezuela--are facing price pressures following sustained periods of rapid growth or large exchange rate depreciations.
[FIGURES 1.3-1.4 OMITTED]
Against this background, central banks in the major advanced economies have taken steps to tighten monetary conditions. The U.S. Federal Reserve continued to raise the Fed funds rate through June, although pausing in August, seeking to balance inflation concerns against signs that the U.S. expansion is beginning to slow (Figure 1.5). The European Central Bank has raised its policy rate further, and the Bank of Japan has moved away from quantitative easing and in July raised the overnight policy rate from zero to 25 basis points. Central banks in Australia, Sweden, and the United Kingdom have also tightened in recent months. Longer-term government bond yields have increased, although they still remain quite low in real terms relative to average levels over the past 25 years (Figure 1.6).
[FIGURES 1.5-1.6 OMITTED]
Since late 2005, the U.S. dollar has depreciated against the euro, and to a lesser degree the yen, partly reversing its appreciation during the previous 12 months (Figure 1.7). The recent depreciation of the U.S. dollar seems to reflect in part perceptions that with the U.S. expansion at a more mature stage, interest differentials vis-a-vis the other major currencies are likely to narrow, as well as increased market concern with global imbalances as the U.S. current account deficit has continued to widen and the surpluses in parts of emerging Asia and oil exporters have increased further (Figure 1.8). In real effective terms, the U.S. dollar is now close to its average level since 1980, while the euro is somewhat above its long-run average in real terms, and the yen somewhat below. Volatility in currency markets has also risen back to more normal levels, in part reflecting the fact that monetary policy decisions have become more data dependent and harder to predict.
[FIGURES 1.7-1.8 OMITTED]
Rising inflation concerns and tightening by major central banks had a marked impact on financial markets during March-June, 2006. Starting in March, currencies of some countries with particularly wide current account deficits--Iceland, New Zealand, and Hungary--depreciated sharply. There was a more general retreat from equity markets and emerging market currencies in May and June (Figure 1.9 and Box 1.1). Particularly affected were asset prices that had previously risen sharply (such as equities in Colombia and India), and the exchange rates of countries with high current account deficits (such as Hungary, South Africa, and Turkey). (1) With these developments coming on top of already overheated conditions in some countries, a number of central banks in emerging market countries have raised rates to calm financial conditions and to head off inflationary pressures. Since July, however, conditions have been more stable.
[FIGURE 1.9 OMITTED]
The IMF staff's assessment is that these market events should not significantly slow the overall momentum of global activity, although growth in some individual countries (such as Turkey) may be dampened. For the most part, asset price declines seem to have represented corrections after major run-ups rather than a fundamental reassessment of economic risks. It is striking that the impact on emerging market external bond spreads was relatively subdued, in part reflecting progress made in strengthening fiscal positions and the buildup of international reserve cushions, as well as recent debt buyback programs that have improved the supply-demand balance in these markets. Welcome progress has also been made in improving the structure of public debt, with increased sales of local currency debt to foreign investors, although some of the wind was also taken from these markets in the recent correction. Nonetheless, recent market pressures have provided a timely reminder of the need for continuing progress to improve public sector balance sheets and to address other vulnerabilities.
Oil and other commodity prices continued at elevated levels in the first eight months of 2006, with petroleum and metals prices reaching new highs (Appendix 1.1). Oil prices have been supported by tight spare capacity in global markets--both in production and refining--against the background of buoyant GDP growth, security concerns in the Middle East, and continued risks to production in some large producers elsewhere (notably Nigeria). Metals prices also have been boosted by strong demand growth, especially in emerging markets, by capacity shortages, and by labor disputes. Prices of food and other agricultural products rose in relative terms in the first part of 2006, although they have not participated in the price boom affecting oil and metals in recent years. Against this background, some commentators have suggested that speculative activity may have contributed to recent price surges, particularly in oil and metals. However, an IMF staff analysis, reported in Chapter 5, suggests that while speculators may have played a role in providing liquidity to markets, speculative position-taking does not seem to have been a significant driver leading commodity price movements.
Outlook and Short-Term Risks
Notwithstanding tightening financial conditions, the baseline forecast for world output growth has been marked up to 5.1 percent in 2006 and 4.9 percent in 2007, 1/4 percentage point above the April 2006 WEO projection in both years (Figure 1.10). (2) This would be the strongest four-year period of global expansion since the early 1970s. This favorable outlook depends on the view that inflationary pressures will be successfully contained with modest further interest rate increases by the major central banks, that the growth of domestic demand will be better balanced across the advanced economies, that emerging and developing countries will largely avoid capacity bottlenecks, and that global financial market conditions will be more stable now that excessive valuations in some sectors have been reduced. More specifically:
* The U.S. economy would grow 3.4 percent in 2006, before slowing to 2.9 percent in 2007, broadly in line with potential. A cooling housing market would continue to dampen private consumption and residential investment, but corporate investment should be supported by high capacity use and strong profitability.
* Growth in the euro area would rise to 2.4 percent in 2006--its highest rate in six years--before moderating to 2 percent in 2007. Stronger corporate balance sheets have paved the way for higher investment, rising employment, and a better balanced expansion. The slowing in 2007 would largely reflect scheduled tax increases in Germany.
* The Japanese economy would grow by 2.7 percent in 2006, based on solid domestic demand, before easing to 2.1 percent in 2007.
* Growth in emerging markets and developing countries would remain very strong at 7.3 percent in 2006, and slow only marginally to 7.2 percent in 2007. China would sustain growth around 10 percent--an upward revision relative to the April 2006 World Economic Outlook--while India and Russia would also continue to grow rapidly. Latin American countries would continue to lag, although growth prospects have been marked up in this region.
* Headline inflation in the advanced economies would increase modestly to 2.6 percent in 2006, and start to come down in 2007 as the upward impetus from oil price increases recedes. Inflation pressures would also generally be contained in emerging market and developing countries.
* The U.S. current account deficit would rise further--to 6.9 percent of GDP in 2007--with large surpluses continuing in Japan, parts of emerging Asia, and oil-exporting countries in the Middle East and elsewhere.
* Private capital flows to emerging market and developing countries would slow from the torrid pace of 2005, but with the overall net current account surplus of these countries rising further, the pace of accumulation of international reserves would remain high (Table 1.2).
[FIGURE 1.10 OMITTED]
The risks to this baseline forecast would seem, however, increasingly tilted to the downside, even more so than at the time of the April 2006 World Economic Outlook. As reflected in the fan chart for global growth (Figure 1.11), which is based on the past forecasting record and an assessment of the current distribution of risks, in the IMF staffs view there is a one in six chance of growth in 2007 falling to 3 1/4 percent or less, a significant slowdown compared to the last four years.
[FIGURE 1.11 OMITTED]
Before considering these downside risks in more detail, it is worth highlighting sources of potentially even more rapid growth. These would seem to be concentrated in emerging markets, where growth has been underpredicted by IMF staff in recent years. In China, in particular, investment could be even higher than projected, in part reflecting abundant banking system liquidity, although such an outcome would further increase concerns about a boom-bust investment cycle. More broadly in emerging markets, a return to calmer global financial conditions could presage a resurgence of portfolio inflows, which could foster easy monetary conditions, a rebound in asset prices, and a further strengthening of domestic demand. In the advanced economies, the main upside potential would seem to be in business investment, given strong corporate profitability and rising capacity utilization.
Turning now to the downside, markets have been concerned that a continued buildup of inflation pressures in advanced economies could require a more aggressive monetary policy response to cool the growth momentum, particularly in the United States. Clearly, there are risks in this direction coming from tightening capacity constraints and the continuing potential for high headline inflation to seep into price expectations and bolder wage demands. Cost push pressures have risen in the United States in recent quarters, reflecting both rising employee compensation and slowing productivity as the expansion matures, although unit labor cost growth has remained subdued in the euro area and Japan (Figure 1.12).
[FIGURE 1.12 OMITTED]
A related risk to the outlook comes from the continued potential for supply-side shocks in the oil market, which could give a further upward impetus to international oil prices, thus exacerbating inflationary pressures while cooling household demand. In the baseline forecast, the international oil price is expected to average $75 a barrel in 2007, close to the peak reached in early August (see Appendix 1.1). As emphasized in past issues of the World Economic Outlook, up to now the global economy has been able to absorb quite well the run-up in oil prices, reflecting that--to a considerable degree--the price increases have been driven by strong demand growth rather than supply constraints, and that central banks have had the credibility to focus on core rather than headline inflation. The decline in energy intensity of global output compared to the 1970s has also played a role in containing the impact of oil price increases. However, with spare capacity remaining at recent very low levels, supply concerns have played a growing role in pushing up oil prices, and a major disruption in a large producer or a further escalation of security concerns in the Middle East could well lead to another upward oil price spike. (3) Over time, investment in new production and refining capacity both inside and outside the Organization of the Petroleum Exporting Countries (OPEC), diversification into alternative energy sources, and increased conservation efforts by consumers responding to price incentives should restore spare capacity to more comfortable levels, but the lags are lengthy, and considerable uncertainty remains about the pace and extent of these responses.
There are also supply-side risks from non fuel commodity prices. In total, nonfuel commodities represent almost twice as large a share of world trade as fuels and can have an important impact on the global economic environment, both for consumers and the exporters, which (like oil) tend to be in emerging market and developing countries. In fact, for a number of these countries, nonfuel commodity price increases have provided significant terms-of-trade gains or at least offset some of the losses from higher oil import bills (Figure 1.13), while in some countries like Chile government revenues from these sectors are an important share of total revenues.
[FIGURE 1.13 OMITTED]
Chapter 5 of this report discusses the prospects for nonfuel commodity markets in more detail. Its analysis suggests that, as with oil, recent price increases have been substantially driven by a surge in demand, particularly in rapidly growing, large emerging markets like China. This surge in demand has outstripped supply capacity, especially in metals where supply responses ale subject to longer lags than in agriculture. However, unlike the petroleum market, nonfuel commodity prices are expected to retreat more rapidly from recent highs as new capacity chines into operation, although not to fall back to earlier levels--in part because higher energy costs have boosted costs of production. Nonfuel commodity exporters will thus need to be cautious in managing the uncertain stream of foreign exchange earnings and government revenue from these sources.
A key risk on the demand side is that the continued cooling of advanced-economy housing markets will weaken household balance sheets and undercut aggregate demand. At this point, concerns center on the United States, although other markets, such as those in Ireland, Spain, and the United Kingdom, also still seem over-valued by most conventional measures. In the United States, the April 2006 issue of the Worm Economic Outlook suggested that, by 2005, average home prices had risen around 10-15 percent above levels consistent with fundamentals. Recent data indicate that the market is now softening quite rapidly, with home sales and mortgage applications weakening, housing starts falling, and house price increases dropping. The baseline U.S. growth forecast assumes house price growth will continue to slow, implying a drag on domestic demand from the housing market of approximately 1/2...
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