Global Economic Prospects 2007/2008: Moderately Slower Growth and Greater Uncertainty

For the fifth consecutive year, global economic growth will exceed 4 percent and will be in the neighborhood of 5 percent for the fourth consecutive year-the strongest sustained global economic advance since the boom of the 1960s. The slowdown in the United States since early 2006, recent indications of slowing in Europe and Japan, concern that stronger efforts will be needed to contain inflation in China, and turbulence in world financial markets arising originally from concerns about US subprime mortgages raise uncertainty about growth for 2008. A substantial global slowdown, led by a possible recession in the United States and trouble in the Chinese economy, is clearly a risk. The more likely outcome for 2008, however, is moderately slower global growth, in the neighborhood of 4 percent. Beyond 2008, global growth is likely to remain in the 4 percent range, with the industrial countries advancing sedately at a little better than 2 percent, and the developing countries, led by China and India, charging forward at a pace somewhat better than 6 percent.

Surging world commodity prices, especially for energy, reflect the rapid recent pace of global economic growth and the particularly rapid growth in emerging-market countries that are heavy users of energy and other primary inputs. So far, rising commodity prices have not been reflected in much increase in consumer price inflation, especially core inflation that excludes food and energy prices. Tightening of monetary policies in most industrial countries and several emerging-market countries generally appears likely to be sufficient to keep inflation reasonably in check, although there are some countries where further policy efforts are likely to be needed and where output growth may need to slow.

While global growth prospects continue to look reasonably good and global inflation appears likely to remain generally well contained, risks to global economic performance are greater than in recent years.

In this regard, the risks that have received greatest attention recently are those potentially arising from the turbulence in global financial markets that started in late July due initially to concerns about financial instruments embodying claims on subprime mortgages in the United States. These concerns then spread to a much wider class of short-term financial instruments and had significant repercussions in financial markets in both Europe and the United States (including some spillover to markets for credits of emerging-market countries).

In my view, it was appropriate for major central banks to respond to the turmoil with injections of credit and some modest reductions in policy interest rates. When important credit markets begin to cease to function normally, there is always a danger that the crisis may deepen and the real economy may feel significant adverse effects. It is wise to take moderate precautions to help assure that this process does not get out of hand.

However, it is important to be careful not to exaggerate the likely economic effects of financial-market turbulence. In my 25 years of forecasting the US economy, the worst mistake I ever made was in late 1998. The global financial-market turbulence following Russia's default and the collapse of the hedge fund Long Term Capital Management had created worries of severe economic fallout, even with actions taken by major central banks to calm the markets. Sharing these concerns, in late 1998, I was instrumental in persuading colleagues at the International Monetary Fund (IMF) to reduce the forecast for US economic growth in 1999 to 1.8 percent. The actual outcome was growth of 4.2 percent!

The Americas

As expected, real GDP growth in the United States has slowed to just below 2 percent since the first quarter of 2006, and the results for the first two quarters of 2007 came in exactly as forecast, with a very weak first quarter offset by a significantly stronger second quarter to yield 2¼ percent growth during the first half. Available data indicate that the advanced estimate of third quarter real GDP growth, to be released at the end of this month, will come in close to 3 percent. The likely third quarter result reflects a surge in consumer spending reported for August, which is likely to be paid back by very weak or even slightly negative consumption spending growth in September. The carry-over effect from a weak September and other indications that consumers are not in a strong buying mood suggest that consumer spending growth in the fourth quarter will be quite weak. With residential investment continuing its slump through yearend and beyond, the US economy looks likely to achieve barely 1 percent growth in the fourth quarter.

If things turn out this way, real GDP growth during 2007 (i.e., on a Q4/Q4 basis) should closely match the 2¼ percent gain that was forecast a year ago. On a year-over-year basis, the rise in real GDP for 2007 would come in at 2 percent, slightly below the forecast of 2¼ percent. This lower-than-forecast result reflects downward revisions (released in July) to GDP growth estimated for 2006. These revisions, it might be noted, also brought down officially estimated GDP growth for 2006 from 3.3 to 2.9 percent-almost exactly in line with the forecast of two years ago that the US economy would grow 3 percent in 2006. Sadly, however, these results do not indicate exceptionally keen forecasting ability that is likely to carry forward to future forecasts. Good luck is the forecaster's best friend.

Looking forward through the end of 2008, the most likely prospect is that the US economy will continue to grow sluggishly at about a 2 percent annual rate. Specifically, after a weak fourth quarter in 2007, I forecast that US real GDP will increase 2¼ percent on a Q4/Q4 basis during 2008. This implies that year-over-year growth for 2008 should also be about 2 percent, down by ½ percent from the forecast of last April. This half percentage point cut recognizes that growth prospects for the United States now look modestly weaker than they appeared likely to be six months ago.

Following are the details of how the forecast might be realized in terms of the main components of GDP: Real GDP (in 2000 chained dollars) is estimated to be $11,600 billion in the third quarter of 2007. For the US economy to grow as forecast, real GDP would need to reach $11,900 billion in the fourth quarter of 2008, a rise of $300 billion. Where might this gain come from?

Consumption spending accounts for more than 70 percent of GDP. After a good gain in the third quarter of 2007, consumption spending growth is expected to be barely 1 percent in the fourth quarter and then grow at a subdued rate of 2 percent during 2008. This implies a rise in real consumption spending over the five quarters to end 2008 of about $200 billion.

There is good reason to expect that consumption spending growth will be weak, not only exceptionally weak in the fourth quarter but also not very buoyant thereafter. Employment growth has slowed (although not as much as suggested by the August employment report), and the unemployment rate is ticking upward. Reflecting slower employment growth, personal income is likely to grow more slowly. Energy prices have spiked up again, and this is likely to cut somewhat into real consumer spending. House prices are falling, interest rates on many adjustable rate mortgages are still adjusting upward, and some households that want to refinance their mortgages are finding this difficult. Understandably, the consumer mood is not very bright. On the other hand, it is well to recognize that household net worth continues to rise as strong gains in equity values have more than offset the swoon in house prices. More generally, the dominant component of total consumer spending-spending on services including health care-has a consistent upward trend. It would probably take an outright recession to push total consumer spending growth for a year below 1 percent.

In the investment sector, real residential investment has shrunk by 19 percent from its peak in the summer of 2005 to a level of $490 billion in the second quarter of 2007. A further decline to about $475 billion is likely to have occurred in the third quarter. The subprime mortgage mess and broader problems in the mortgage market are clearly adding impetus to the residential investment slump. Further declines in this category of investment now appear likely to take real spending down to $435 billion before it levels off. After that, the overhang of a still large inventory of unsold homes will probably preclude any meaningful recovery in this sector before 2009.

More than a third of the decline in residential investment over the past year has been offset by strong gains in business investment in nonresidential structures. This boom is unlikely to continue, but there is little indication yet of an impending crash. Business investment in equipment and software has grown more sluggishly than expected, with less than a 1 percent rise over the year to the second quarter of 2007. The sharp decline in transportation equipment investment since end 2005 reflects special factors that are unlikely to be repeated (unless there is a recession). Real business investment in information processing equipment will probably show continued growth. All together, business fixed investment (including structures) may reasonably be expected to post a modest gain of about $30 billion through end 2008.

Inventory investment was barely positive in the second quarter and does not appear to have posted large gains in the third quarter. This implies that there is room for inventory investment to rise by about $25 billion through the end of 2008 without inventories becoming excessive. Significantly larger gains would be helpful to GDP growth in the near term but would also be an important warning signal of future recession.

Adding together the expected results from the various components of real investment, the expected contribution to real GDP growth over the next five quarters is only barely positive at about $15 billion.

Government spending grows erratically from quarter to quarter but has a fairly consistent upward trend of about 1½ percent real growth in recent years. With no reason to anticipate large increases or decreases in federal spending, and with state and local governments coming under some budgetary pressure from slumping real estate taxes and revenues related to residential construction, it is reasonable that real government spending growth will be a little below this trend over the next five quarters, implying an expected contribution to the gain in real GDP of $30 billion.

Real net exports leveled off at a deficit of about $630 billion for the two years from the fourth quarter of 2004 through the third quarter of 2006. Since then, the significant slowdown in demand growth in the US economy, together with strong demand growth abroad, and the effects of significant real effective depreciation of the dollar since its peak in early 2002, have yielded an improvement in US real net exports of $60 billion through the second quarter of 2007. Part of the improvement in the second quarter reflected an unusual decline in real imports that (barring a US recession) is unlikely to be repeated and will probably be partially reversed in the third and fourth quarters. This aside, the same factors that produced improvements in real net exports since the summer of 2006 are likely to continue to operate in coming quarters (and years): Growth of domestic demand in the United States is likely to remain quite sluggish, curtailing import growth, and continued relatively strong demand growth abroad and a further weakened dollar are likely to keep US export growth quite buoyant.

From where we are projected to be in the third quarter (a real net export deficit of about $580 billion), over the next five quarters, improvements in real net exports may reasonably be expected to contribute about $50 billion to the increase in US real GDP.

Adding together the contributions from the four components of GDP (consumption, investment, government spending, and net exports) yields a total of $295 billion-close enough in this kind of exercise to the $300 billion of real GDP gain in the overall forecast. Of course, even if the overall forecast proves amazingly accurate, it is highly unlikely that the details will work out exactly as just described. Nevertheless, the exercise is useful both as a check on the reasonableness of the overall forecast and as an indication of where the principal risks may lie.

On the upside, real consumption spending growth of $250 billion or even $300 billion through end 2008 is certainly feasible if the economy grows somewhat more strongly than forecast and perhaps especially if rising equity values continue to more than offset declining house prices. The further decline in residential investment could be a little less than has been assumed, and business investment in nonresidential structures might continue growing, albeit on a more modestly rising path. With a more strongly growing US economy, business investment in equipment and software would likely grow somewhat more rapidly than has been projected. Real government spending would be little affected by these developments, and with stronger US consumption and investment growth, real net exports would probably show less improvement than has been assumed. Nevertheless, the result of these possible upside developments could place the gain in real GDP by end 2008 in the range of $350 billion to $450 billion, implying an annualized real GDP growth rate of 2½ to 3 percent.

On the downside, the likely slowdown of consumer spending growth in the fourth quarter could extend into the first half of next year, which would feed back through reduced income and employment growth to slow consumption growth in the second half. Falling equity values, perhaps induced by evidence of economic weakness, could further deter consumers. The further fall in residential investment could be deeper and go on longer than has been assumed, and recent boom of business investment in nonresidential structures could turn toward slump. In this environment, business investment in equipment and software might begin to turn downward. Gains in inventory investment might temporarily offset some of this weakness, but this would be paid back quite rapidly. Government spending would be little affected and net exports would likely improve more than has been assumed in the baseline forecast. The overall result in this downside scenario could be a real GDP gain through end 2008 of zero to $150 billion, implying annualized real GDP growth between 0 and 1 percent over the next five quarters. This would be entirely consistent with a brief recession beginning late this year or early next year with recovery starting later in 2008-essentially the same pattern as in the brief 2001 recession.

Looking to possible effects from economic policy, fiscal policy will remain in neutral. Aside from extending some existing tax breaks (including a temporary fix to keep the alternative minimum tax in check), no significant tax cuts or tax increases will make it into law. Significant changes in federal spending will also be checkmated by the Democratic-controlled Congress and President Bush's veto pen.

As far as monetary policy is concerned, the Federal Reserve eased its discount rate in early August amidst concerns about turbulence in credit markets and cut the target federal funds rate by 50 basis points in mid September. Financial markets celebrated the latter action, with the Dow Jones Industrial Average and the S&P 500 Index both rising above the historic peaks reached in July by early October.

The cut in the federal funds rate is plausibly justified by evidence that inflation is continuing to recede and data indicating that economic growth going forward is likely to remain subdued, as well as continued concern about turbulence in credit markets and its possibly broader economic implications. In the statement accompanying the federal funds rate cut decision, the Federal Open Market Committee (FOMC) formally indicated a neutral bias with respect to further interest rate actions. However, the de facto bias is clearly toward further easing: No one expects the Fed to tighten any time soon; but the Fed clearly left the door open to further funds rate cuts. Whether the Fed walks through that door will depend on what incoming information suggests about the evolving balance of risks for growth and inflation.

If the fourth quarter turns out to be weak as expected, another one or two 25 basis point rate cuts by the Fed between now and the late January FOMC meeting should not be surprising. Beyond that, however, the Fed is likely to, and would be wise to, hold back from more substantial interest rate cuts unless and until there is more persuasive evidence that the US economy is headed toward recession. Monetary policy can help to moderate recessions and keep them relatively brief, but it cannot always avoid them, and it is a mistake to try too hard and too frequently. Overly aggressive action to try to smooth out every bump and wiggle in the economy can add to economic volatility rather than reduce it.

Turning to Canada, growth in 2007 looks likely to come a little above the 2½ percent in the April forecast. The strong appreciation of the Canadian dollar, to above parity with the US dollar, reflects resurging world energy prices, as well as factors tending to weaken the US currency more generally. The strong loonie will hurt Canada's noncommodity exports but will benefit Canadian consumers through an important real terms-of-trade gain. The effect of this real income gain is likely to be felt (as have earlier such gains) in generally strong consumer spending, not just spending on imports. On balance, it is likely that the Canadian economy will expand at a 2½ percent pace through 2008. The spillover effects from continued weak growth south of the border and the strong loonie will be offset by continued strong consumption gains and reasonably buoyant investment.

If this is what happens, the Bank of Canada is likely to remain on the sidelines. The strong Canadian dollar should take care of earlier concerns about rising inflation, removing any need for the Bank of Canada to tighten. On the other hand, barring a US recession, Canada's economic growth should be sufficient without any boost from monetary easing. If the United States did fall into recession, the Bank of Canada would need to weigh its options carefully, with an eye to what is happening to the exchange rate. If the Fed cuts US rates aggressively and the exchange rate of the Canadian dollar soars even higher, some defensive interest rate cutting by the Bank of Canada might be in order.

For Mexico, the second quarter GDP results showed strong recovery after earlier weakness, and growth this year appears likely to be in line with the forecast of 3 percent. Inflation, which exhibits a strong seasonal pattern, has recently been trending up on a month-over-month basis but remains well contained on a year-ago basis. Monetary policy is committed to achieving the inflation target and is well-managed to do so. Domestic real interest rates are suitably positive but sufficiently moderate to not pose a barrier to reasonable rates of economic growth. Fiscal policy is maintaining appropriately tight restraint with the result that the primary fiscal balance remains near zero. The exchange rate of the peso appears neither overvalued nor undervalued, and the trade and current accounts are running near overall balance.

Domestic consumption and investment are growing at respectable rates and appear likely to continue to do so. With its very close links to the US economy, however, it is difficult for the Mexican economy to sustain much more than 3 percent growth when the US economy is growing only at 2 percent. As US growth is not expected to pick up through 2008, it is unreasonable to expect that growth of the Mexican economy will accelerate very much from the 3 percent pace of 2007.

The economy of Brazil is not closely tied to that of the United States. This year Brazil looks set to achieve nearly 5 percent real economic growth, modestly above my somewhat optimistic forecast of 4 percent. The same factors that produced this performance in 2007 appear likely to produce only modestly slower growth in 2008.

Real interest rates in Brazil have come down substantially over the past four years, as the success of the central bank in achieving its inflation target has increased confidence that inflation will not again be allowed to get out of control. This increasing confidence in consistent inflation control has enabled the central bank to cut gradually its short-term policy interest rate, the Selic rate, by more than the decline in inflation, thereby allowing domestic real interest rates to decline from very high levels. This, in turn, has contributed to a moderate resurgence of domestic demand. As short-term real interest rates remain in the neighborhood of 9 percent, there is room for this process to continue (at a gradual pace), thereby providing some additional support for domestic demand growth. Meanwhile, fiscal policy has retained tight control over the budget deficit, reducing the ratio of government debt to GDP and increasing confidence that Brazil will not return to the destabilizing policies of the past.

One of the side effects of these important policy successes is visible in the strong appreciation of the Brazilian currency, the real. From over 3 reals to the dollar in 2003, it has appreciated to about 1.8 reals to the dollar now, and Brazilian inflation over this period was meaningfully above US inflation. Of course, the appreciation of the real since 2003 was from a highly overdepreciated level, reflecting the crisis of confidence in Brazil's economic policies in the run-up to the 2003 elections. Nevertheless, there must be some question about what the recent further real appreciation of Brazil's currency (especially against its leading trading partner, Argentina) may portend for the future contributions of net exports to Brazil's GDP growth.

Turning to Argentina, anticipated growth this year of 7½ percent appears once again to exceed most forecasts, including my relatively optimistic (at the time) April forecast of 6½ percent growth. Underneath continued strong growth, however, imbalances in the Argentine economy continue to increase. Even the officially reported inflation rate is high by the current standards of Latin America's main economies at about 9 percent per year, but this figure seriously understates actual inflationary pressures. The government continues to repress price increases through direct controls (for example, on utility rates) and by jawboning. In addition, the tactic of simply lying about what the inflation data actually show has been adopted. Meanwhile, nominal wages are advancing rapidly, which is surely not a political liability for Argentina's president, whose wife is running to succeed him.

Eventually, policy regimes like that operating in Argentina break down, usually in crises. That does not yet appear imminent in the case of Argentina, which will probably get through 2008 with an officially reported growth rate that is between 5 and 6 percent and an officially reported inflation rate that remains below 10 percent.

Elsewhere in Latin America, growth for 2007 appears to be a little stronger than forecast in April, but the general pattern is consistent with that forecast. Growth in Chile is picking up to nearly 6 percent but will probably slow modestly next year. Venezuela is slowing down somewhat, but growth is still likely to reach about 8 percent this year and slow to about 5 percent. Colombia and Peru are enjoying growth of about 6 and 7 percent, respectively, this year, with the prospect that growth next year will remain solid, although about 1 percent lower than this year.

Asia Pacific

For Japan, negative GDP growth now estimated for the second quarter of 2007 implies that year-over-year growth for 2007 will come in a little shy of the 2¼ percent forecast in April. Recent data, however, do not suggest that the Japanese economy is falling back into recession after nearly five years of generally moderate growth. Growth this year is likely to reach about 2 percent, and a marginally weaker outcome may be anticipated for 2008. The reasons for this are the following.

Potential growth in the Japanese economy looks to be a little below 2 percent and margins of slack, although not eliminated, are also not very broad. (In this regard, the fact that inflation remains near zero is not a sign of substantial margins of slack. It is the change in the inflation rate, not its level, that theory suggests is related to the level of slack, and the inflation rate has come up from modestly negative to around zero.) On the demand side, household saving rates have come down from the high levels of two decades ago, but there is no reason to expect that consumer spending growth will slow below real GDP growth. Business sentiment has become somewhat less optimistic, but there is no reason to expect a downturn of investment. For the external sector, the yen remains very highly competitive in real effective terms, despite its recent modest appreciation against the dollar. The main concern on the export front is that export to the United States might slow and growth of exports to China may become less buoyant. All told, this points to a forecast of 1¾ percent real GDP growth for Japan in 2008 and 2 percent growth this year.

The economy of China continues to deliver remarkably strong growth that looks set to reach 11 percent again this year. The pattern of growth, however, continues to become more unbalanced, with the current account surplus rising over the past four years from 3½ percent of GDP in 2004 to 7 percent in 2005, to over 9 percent in 2006, and based on the trade results so far this year to probably 12 percent of GDP this year. Thus, despite exceptionally rapid fixed investment growth in China for all these years, the Chinese economy has had to rely on substantial improvements in net exports each year to keep GDP rising at a 10 percent annual rate.

It seems unlikely that this pattern can continue much longer. Already China has moved from the world's largest steel importer to prospectively the world's largest steel exporter. In some other key industries, China's trade performance is nearly as spectacular. But there are practical and political limits to how far and how fast Chinese export expansion can proceed as it penetrates increasingly sensitive markets for manufactured goods such as automobiles.

Meanwhile, inflation has been accelerating in China. Rising food prices have had a lot to do with this, but the inevitable pressures from continued very rapid growth are also an important part of the story. The Chinese authorities have moved to tighten monetary policy, but the increases in the central bank's interest rate and efforts to restrain credit growth through quantitative guidance have not proved remarkably successful. The fact is that it is very difficult to maintain monetary control when the country is being flooded with gigantic inflows of foreign exchange reserves that are the consequence of resisting currency appreciation in the face of both massive (and growing) current account surpluses and large capital inflows. The only effective way out of this problem is to scale back official foreign exchange market intervention and allow the exchange rate of the yuan to appreciate significantly more than the 9 percent permitted since July 2005.

The Chinese authorities have been very reluctant to take this step and avidly embrace every silly explanation for why it is not really necessary. This is merely delaying the inevitable and making it more disruptive when it comes-probably not until after the 2008 Olympics. But a prospective current account surplus of perhaps 14 to 15 percent of GDP in 2008 and more thereafter will compel action before very much longer. In the meantime, it is reasonable to suppose that the growth rate of the Chinese economy will slow at least modestly in 2008 as necessary efforts to contain the rise of inflation have some effect.

In India, growth has also been very rapid, especially for the past two years, but not quite as rapid as in China for the past four years. And, India's growth has not been unbalanced as China's has. As one would expect for an economy that is growing faster than most of its trading partners and that is an importer of energy, India's trade balance has deteriorated considerably over the past four years. India's current account balance has also deteriorated but not to such a worrying degree as nontrade current account receipts (including remittances) have grown fairly rapidly. Tightening of monetary policy by the Reserve Bank of India has achieved some success in reducing inflation that began to rise uncomfortably last year. Along with capital inflows chasing India's surging equity markets, monetary tightening probably contributed to the appreciation of the rupee, which has some benefits for inflation control but tends to imply further worsening of the trade balance. It remains to be seen whether the Reserve Bank will need to undertake any further tightening.

As far as growth is concerned, it now looks like the forecast of 8 percent for 2007 may need to be upgraded by ½ percent, but I would hold to the forecast that growth in 2008 will fall modestly below 8 percent.

For the rest of emerging Asia, growth in 2007 appears likely to be in line with the April forecast or marginally stronger. Upgrades in the estimated results for 2006 imply that this is a modest slowdown from last year. For 2008, I continue to expect a further modest slowing, with GDP growth coming in a little above 5 percent. This slowing reflects the impact of continued sluggish growth in the United States, somewhat slower growth in China and Japan, and higher world oil prices.

Growth in Australia this year looks likely to be 1 percent higher than the April forecast of 3 percent. Exports are booming and with a strong labor market and rising incomes consumers are in a buoyant mood. The Reserve Bank's monetary tightening appears to have restrained inflation without much of a negative impact on growth. It appears that my earlier assertions that Australia's potential growth rate is no more than 3 percent and the slack has already been exhausted cannot both be right. Nevertheless, it is prudent to expect that Australia's growth next year is likely to fall back to about 3 percent, or the Reserve Bank will need to be back to monetary tightening. For New Zealand, by contrast, growth this year appears likely to be close to the 2½ percent forecast, and the forecast of similar growth for next year is retained.

Europe

For Western Europe, it appeared for a while that I would need to upgrade my forecast for this year's growth by at least ¼ percentage point. With evidence of somewhat weaker growth after the first quarter, the April forecast of 2½ percent growth in 2007 is retained along with the forecast of 2½ percent growth for the euro area. For 2008, it is still expected that there will be a slight moderation of growth both for Western Europe as a whole and for the euro area. The details are the following.

In the euro area this year, Germany is growing more rapidly than forecast in April, and growth of 2¾ percent is now expected versus 2¼ percent in the April forecast. France, Italy, Spain, and some of the smaller euro area economies now appear to be growing a little more slowly than was anticipated in April. The net result for the euro area is no change from the April forecast. For France and Italy, the outcomes this year are likely to be a little below the 2 percent growth forecast in April, and Spain's growth this year will probably be a little below 4 percent. For France and Italy, growth next year is expected to be about the same as this year. The Spanish economy, however, is likely to have a more substantial slowdown as the booming real estate market returns closer to reality.

For 2008, the slight moderation in the projected growth rate, down to 2 percent, is consistent with the accumulating evidence that the potential growth rate in the euro area is no higher than 2 percent and probably slightly lower. Additional evidence that potential growth is no greater than 2 percent comes from the fact that the unemployment rate in the euro area has declined further over the past year down to 6.9 percent while the economy's growth has been only moderately greater than 2 percent. The fact that the present unemployment rate in the euro area is half of a percentage point below the minimum that was reached during the preceding expansion suggests that margins of slack may already have been exhausted. I would not push this point too hard. Levels of structural unemployment may well have declined in several euro area economies from what they were six or seven years ago-a good thing if it has happened. However, euro area unemployment rates probably cannot keep on declining by half a percentage point per year for much longer without raising inflationary wage pressures.

The European Central Bank (ECB) pumped liquidity into the banking system in the face of recent strains in credit markets and wisely put further policy interest rate increases on hold. I do not expect that the recent credit market turbulence (which in Europe primarily affected investors in US-based assets) will have much impact on economic activity in the euro area. Nevertheless, it was prudent for the monetary authority to act to contain a potential liquidity crisis before things got out of control. For euro area monetary policy, however, the more important considerations were that the necessary firming of policy had already proceeded a considerable distance, inflation data are not immediately threatening, growth in the euro area appears to be slowing somewhat, the strengthening of the euro is to some degree a substitute for further monetary policy tightening, and little risk to the ECB's holding off from further policy tightening for a few months until the balance of risks between too much slowing of growth and real concerns about rising inflation becomes somewhat clearer. Depending on how conditions develop, I would not be surprised either if the ECB held off from further tightening throughout most of next year or if it decided that another one or two interest rate hikes were needed.

Outside the euro area, the UK economy appears set to deliver growth this year that matches or slightly exceeds the 2¾ percent advance that was forecast in April. The tightening by the Bank of England over the past year appears to be succeeding in reducing inflation from uncomfortable levels last year back to the target range. While the economy has been expanding smartly despite a quite firm monetary policy, I expect that there will be some slowdown next year, with GDP growth projected to be 2½ percent. This reflects the slowing that should normally be expected as the consequence of monetary tightening and would bring the British economy back to its potential growth rate. Any lingering effects of the recent turmoil in credit markets on the economy are likely to be modest and may well substitute for an additional step of monetary tightening. Whether the Bank of England will need to move further to ensure that inflation remains in check or whether it may instead need to ease policy over the next few months is not clear at this stage.

The smaller Western European economies that are not in the euro area (Norway, Sweden, and Switzerland) are all having strong years. Growth is down a bit from unsustainably rapid rates last year in Switzerland and especially Sweden. The Swedish Riksbank has continued to tighten despite the recent global financial turmoil and may need to tighten somewhat further to keep inflation at its target rate. Growth may be expected to slow next year to 3 percent from 3½ percent this year. In Switzerland, growth is also likely to slow, from 2½ percent this year to 2 percent next year. Inflation, which is running below 1 percent this year may edge up slightly. This is not a grave concern for the Swiss National Bank, which will probably keep one eye on the exchange rate in deciding whether further policy adjustments are needed. For Norway, the benefits from oil export revenues are likely to keep the economy humming.

In Central and Eastern Europe, the diagnosis in April remains on track. "For 2007 and 2008, growth in Central and Eastern Europe appears likely to be modestly below 2006. Hungary is facing considerable challenges in bringing down its large budget and current account deficits, and growth there is unlikely to much exceed 2 percent. Elsewhere, the story is mainly that countries that last year grew more strongly than their respective averages of the past few years will tend to see their growth rates fall back toward these averages."

The results reported over the past six months generally confirm this assessment. Turkey's growth this year will likely come in around 5 percent, down from about 6 percent in 2006. Poland will probably sustain growth of about 6 percent. The Czech Republic will grow about 5½ percent, down one percent from 2006. Hungary's economic growth will be ½ percent above 2 percent and down from 4 percent in 2006. For the region as a whole, growth this year will be about 5½ percent, down from 6 percent in 2006. For 2008, the prospect is that growth will moderate slightly to about 5 percent.

Commonwealth of Independent States, Middle East, and Africa

Commodity exports, especially oil, remain key to the economic performance of many of the countries in these diverse regions.

In the build up to the coming presidential election, Russia's economic growth this year is likely to reach 7 percent, by a small margin the highest in the past three years, and slightly above the April forecast. Growth has been led by strong rises in consumption and domestic investment. Large increases in oil revenues have helped to fuel this expansion, and the rise in export revenues has far outstripped large increases in imports, which have more than doubled of the past three years and clearly headed higher. Inflation has come down to near the central bank's target of 8 percent, but huge increases in the money supply suggest that problems may well lie ahead. A crimp on the boom, however, is unlikely before the election, so one should not anticipate much of a slowdown for 2008.

Elsewhere in the CIS, economic growth in the Ukraine has been marginally disappointing at around 6½ percent. Oil-rich Kazakhstan continues to boom as do the other oil exporters among the smaller CIS states. This may be expected to continue into 2008 at least.

In the Middle East, the oil exporters continue to do well, especially if economic advance is measured in consumption value terms (i.e., measuring output in the oil sector in terms of what it will buy rather than in physical volume terms). In Egypt, with its more diversified economy, growth is running about 7 percent and is likely to continue at about this pace.

In Africa, growth generally remains quite strong and is likely to come in this year somewhat above the April forecast of 5 percent. The largest economies, Nigeria and South Africa, are growing at about 6 and 5 percent, respectively, with Nigeria helped by oil and hurt by continuing social unrest. For 2008, growth in Africa is expected to be about the same as this year.

Forecasts are reported here in ¼ percent intervals because the accuracy of GDP results is no better than that. Aggregation of these forecasts yields a euro area forecast that is a little below 2½ percent, which is rounded up. The aggregate forecast for all of Western Europe is a little above 2½ percent and is rounded down. This accounts for the fact that the forecasts for Western European and euro area growth are both 2½ percent each for 2007, even though growth outside of the euro area (for the United Kingdom and other countries) is above 2½ percent.

Table 1 Real GDP growth projections as of October 10, 2007
(percent change, year over year)

WEO = International Monetary Fund, World Economic Outlook