Global Economic Prospects: On Track for Strong Growth in 2004 But Worries About 2005

Overview

For 2004, the world economy appears set to achieve at least 5 percent real GDP growth on a year-over-year basis-slightly better than the 4¾ percent forecast in early April and the strongest in two decades. But, higher oil prices and declining momentum in the US and Chinese economies suggest that global growth may fall slightly short of the 4 percent previously forecast for 2005.

At this stage (mid-September 2004), year-over-year real GDP growth rates for 2004 are already largely determined-even if the data are not yet fully reported. The recent slowing of growth in the US economy suggests that year-over-year real GDP growth may fall slightly shy of the 4½ percent forecast in April. However, this should be offset by stronger than forecast growth in Japan and much of emerging Asia. Latin America is also performing more strongly than was anticipated six months ago, as is much of Central and Eastern Europe, while Western Europe is performing about as expected.

This strong result for 2004 on a year-over-year basis primarily reflects exceptionally strong growth in a number of countries (including China, the United States, and Japan) in the second half of 2003 and early 2004. Growth has clearly slowed in a number of countries in the second quarter and appears likely to proceed at a more restrained pace for the remainder of the year. This is reflected in a fourth-quarter-to-fourth-quarter (Q4/Q4) forecast for 2004 that is slightly over 4 percent-as compared with the year-over-year forecast of 5 percent real GDP growth.
Nevertheless, the year-over-year outcome for 2004 will be well above the potential growth rate of world real GDP. Hence, one would normally expect some slowdown for 2005. Now, especially with the sharp increase in world oil prices since early April, it appears that a slightly greater slowdown-to 3¾ percent global real GDP growth for 2005-appears likely.

Meanwhile, led by strong rises in commodity prices, inflation rates have begun to pick up around the world. With many commodity prices falling back somewhat from their surges early this year, one cause of generally higher inflation rates is receding. However, world oil prices peaked this summer (generally three or more months behind other commodities) and even with the recent weakening remain substantially above their levels of early this year and even more so relative to average oil prices in the past few years. Some of the pass-through effects of higher energy prices to broader price indices are probably still to be felt.

More generally, rates of change of broad indices of consumer and producer prices have begun to pick up somewhat from their lows of the past couple of years; and it is now clear that the low point for global inflation has been passed. Nevertheless, virtually nowhere does the threat of rising inflation (and the inevitable policy responses to that threat) yet raise significant concerns about continued global economic expansion.
With the notable exceptions of Japan and the euro area, industrial-country central banks have begun to tighten their monetary policies. Some developing countries (including China) have also moved to tighten monetary conditions. Despite these actions, the overall stance of monetary policies around the world remains broadly accommodative. Likely further policy tightenings over the next year or so will generally reduce the degree of accommodation rather than apply significant restraint.

A couple of European countries and some developing countries where growth recently has been disappointing are planning some fiscal stimulus to boost activity. More generally, however, fiscal policies appear likely to move modestly toward consolidation over the next year or so, including in the United States and Japan. On balance, fiscal policies appear unlikely to have much effect on global growth, although the temporary effects of the recent large-scale fiscal stimulus in the United States will be wearing off even if there is no significant move toward consolidation.

Key Risks-Oil Prices, Payments Imbalances, and Terrorism

The forecast for global growth embodies the assumption that world oil prices will behave about as predicted in oil futures markets. Specifically, for light sweet crude (the top grade), the futures market now envisions prices declining from $44 per barrel in October 2004 to $39 per barrel by December 2005-yielding an average price of about $41 per barrel for 2005.

This average is more than $10 per barrel above the average futures price for light sweet crude for 2005 envisioned in early April this year. Normally, an increase in world oil prices of $10 per barrel is thought to depress global real GDP by ½ to 1 percent within one to two years. In this case, the escalation of world oil prices should affect global economic activity primarily in the second half of 2004 and in 2005-contributing importantly to the slowdown in the pace of global economic expansion from over 5 percent per year in the second half of 2003 and early 2004 to only about 4 percent per year through the end of 2005.

Of course, as dramatized by the recent instability of world oil prices, forecasts of their future course are subject to considerable error. This uncertainty remains a key risk factor for the global economy.

On the one hand, the demand-supply balance in the global oil market has been tightened by increases in global economic activity that have recently pushed up the world demand above 80 million barrels per day, as well as by disruptions to supply from Iraq and other sources. Available excess capacity for increased oil production from Saudi Arabia and a few other sources is essentially tapped out, reported privately held inventories of oil and oil products are relatively low, and official reserve stocks are said to be available only for unspecified national security emergencies. In this situation, further supply disruptions that might cut global output by a million or two million barrels per day for six months to a year could induce another sustained upward spike in world oil prices. If this were to happen, global growth for 2005 would likely fall meaningfully below potential.

On the other hand, it appears that part of the recent rise in world oil prices to a peak of nearly $50 per barrel was based on speculative pressures. If not supported by changes in the underlying global demand-supply balance, such speculative pressures tend to be naturally self-limited and self-reversing. Very high prices induce some reduction of demand and some increase in supply, leading to gradual gains in inventories that provide an enhanced cushion against temporary disturbances. Prices may drop suddenly and substantially as speculators sell out on fears of losses from falling prices. In this case, there would be a boost to global real GDP growth of as much as ½ percent for 2005-06.

Another source of global economic risk arises from the necessary correction of the large US external payments deficit. This will require (1) a substantial further depreciation of the US dollar against most other currencies, (2) a slowing of domestic demand growth in the United States below output growth, and (3) a rise of output growth relative to domestic demand growth in the rest of the world. If these adjustments occur gradually over the next few years, it should be feasible for the world economy to recover and grow along its potential output path. A modest strengthening of demand growth in the rest of the world (aided by appropriate monetary policies) could offset the otherwise depressive effect of a moderate reduction of demand growth in the United States (assisted by meaningful fiscal consolidation). However, a disorderly adjustment process, involving a sudden sharp drop in the dollar, could impair global growth. This danger is probably greatest if the adjustment process is first delayed and then accelerates at a time when the US economy is operating very close to (or even above) potential.

The threat of terrorist actions is often cited as a major risk to growth of the world economy. In my view, however, the direct economic effects from the terrorist attacks, including September 11, 2001, in the United States, have been more modest than is generally believed. (And, the effect of attacks on Iraqi oil facilities is really a separate issue that is reflected in the more general risks arising from uncertainty about world oil prices.)

Notably, in the United States the recession of 2001 started well before the terrorist attack, and the recovery from that recession started very soon after the attack. Some industries such as commercial airlines and tourism have clearly suffered longer-term damage that is at least partly the consequence of reactions to the September 11 attacks. Also, the vigorous policy response following the attacks, together with the substantial policy stimulus supplied prior to the attacks, helped keep the recession in the United States relatively brief and mild. Nevertheless, in the overall performance of the US economy since September 11, 2001, it is difficult to see much evidence of dire economic consequences from the attacks.
In fact, the region where economic growth has been most disappointing in recent years has been continental Western Europe. Notwithstanding the terrorist attack in Spain earlier in 2004, there is no credible way to attribute disappointing growth in most of continental Western Europe over the past three years to the effects of terrorism.

In view of its painful and dramatic human costs, it may seem unsympathetic to suggest that terrorism is not a major cause of recent economic weakness and a central risk for future economic activity. And, there is always the worry that the terrorists might somehow find a way to "go nuclear" and inflict damage on a scale far greater than we have so far experienced. However, economic forecasts should be based on realism, not on sentiment-nor on the desire to appear "politically correct."

The Americas

After rising at more than a 6 percent annual rate in the second half of 2003 and at a 4½ percent annual rate in the first quarter of 2004, US real GDP growth slowed to slightly below 3 percent in the second quarter. Recent data suggest that growth has picked up somewhat in the summer and should come in between 3 and 4 percent. I expect that growth at about this same pace should continue in the fourth quarter. This means that my April forecast of Q4/Q4 real GDP growth of the US economy for 2004 needs to be cut from 4 to 3½ percent. I would also shade down my Q4/Q4 forecast for real GDP growth during 2005 to 3¼ percent.
These downward adjustments of the forecasts from April imply that the projected level of US real GDP at the end of 2005 has been cut by three quarters of 1 percent (½ percent during 2004 and ¼ percent during 2005). This reflects primarily the impact of higher than expected oil prices. The fact that the April forecasts already envisioned a slowdown in US real GDP growth reflects the assumption that the effects of fiscal and monetary stimulus would begin to wear off (or be even partially reversed) after mid-2004.

Despite waning policy stimulus and the effects of higher energy prices, US economic growth should continue to be reasonably well sustained by household consumption and business investment. Real net exports should also make a more positive contribution to real GDP growth-at least in the sense that further deterioration of net exports will make smaller negative contributions to US output growth than in recent years.

Underlying this economic forecast of the United States are the assumptions that (1) potential output growth is about 3¼ percent (made up of about 1 percent labor force growth and 2¼ percent from the effect of productivity growth; and (2) that there remains at least a modest margin of slack in the US economy.

Assumptions are discussed by Martin Baily.) Together these assumptions imply that with the US economy projected to grow at barely more than 3¼ percent from now through the end of 2005, there should be no significant upward pressure on wage and price inflation. Also, provided that productivity advances in line with my assumption, growth of the economy should generate new jobs consistent with the normal expansion of the US labor force and keep the unemployment rate essentially stable. Consistently rising employment should, in turn, support consumer confidence and help to sustain moderate growth of domestic demand.
As anticipated in April, the Federal Reserve has begun to tighten its monetary policy with 25 basis point increases in the federal funds rate in late June and mid-August. When the Fed clearly indicated last May its intention to begin a cycle of tightening, financial markets (under the influence of strong employment reports for March, April, and May) came to expect that this cycle would push the federal funds rate above 2 percent by the end of 2004 and above 4 percent by the end of 2005. Interest rates on ten-year treasuries rapidly rose to 4¾ percent on these expectations.

As evidence of a slowdown or "soft patch" in the US economy began to emerge during the summer, financial markets reassessed the likely course of Fed tightening and the appropriate level of longer-term interest rates. Markets now appear to expect that the federal funds rate will not breach 2 percent before the end of 2004 and 4 percent by the end of 2005. I believe that, in the face of output growth that is only in line with potential, the Fed will be more cautious; and the federal funds rate will still be around 3 percent by late 2005. Absent clear evidence that inflation is beginning to become a problem, there is no good reason for the Federal Reserve to be aggressive in raising its policy interest rate.

Along with market expectations of monetary tightening, longer-term interest rates have fallen back from their peaks in the late spring. Ten-year Treasury yields are down about 50 basis points to around 4¼ percent. Mortgage interest rates are down correspondingly. This has helped keep residential construction stronger than expected, although mortgage refinancing is still well off from its peak of last year. All told, reactions in financial markets to diminished expectations of monetary tightening are clearly helping to provide a partial cushion to higher oil prices and other factors tending to slow the growth rate of the US economy.

The federal fiscal deficit for FY2004 now appears likely to come in nearly $100 billion below the administration's (February) estimate of about $525 billion. This outcome, however, is not a sudden miracle of fiscal consolidation, but rather the consequence of a bizarre overestimate of the deficit for FY2004. For the next fiscal year, legislative action has not yet been completed, but the realistic prospects are that (assuming the US economy performs as forecast), the federal deficit may decline modestly from the outcome for FY2004.

Looking further ahead to FY2006 and beyond, the platforms of both major political parties implicitly envision continued massive fiscal irresponsibility (i.e., the Washington Post estimates that the proposals of either party would add about $1.3 trillion to the cumulative federal deficit over the next decade). I believe, however, that the outcome will not be so insane. Whoever wins the US elections, modest, gradual fiscal consolidation is likely to be the rule over the next few years. The near-term effects of such consolidation, should it occur, will not pose any significant challenge for continued growth of the US economy.

Looking to Canada, growth during 2004 appears to be marginally weaker than earlier expected-partly reflecting slower than expected growth in the United States as well as the effects of the strengthening of the Canadian dollar over the past two years. But an essentially neutral effect on Canada from higher world oil prices and a gradual wearing off of the effect of the stronger Canadian dollar should allow growth to be sustained at around 3 percent from now through 2005.

In Mexico, there is now greater evidence of an economic pick-up than there was a few months ago, and accordingly the real growth forecast for 2004 is raised moderately from 3¼ to 4 percent. The boost from higher world oil prices and from a Mexican peso that remains significantly depreciated from its level of three years ago should help offset the effect of slower growth in the United States and keep the Mexican economy growing at about this same pace for 2005.

Brazil also has provided evidence of a recent acceleration in economic growth that justifies increasing the year-over-year forecast for 2004 from 3 to 4 percent. Strong growth of exports is contributing importantly to this upgrade for 2004. For next year, I expect that recovery of domestic demand-aided by substantial declines already seen in domestic interest rates-will be the main driving force that will keep growth at 4 percent or slightly higher.

In Argentina, the continued recovery from the devastating crisis of 2001-02 now appears likely to support growth of 7 percent for 2004-as compared with an April forecast of 6 percent. The waning force of this recovery, however, suggests that growth for 2005 will be more modest-probably in the 4 to 5 percent range forecast in April.

In Venezuela, the continuing political and economic crisis depressed real GDP by 9 percent in both 2002 and 2003. A bounce-back now appears likely to yield about 10 percent real GDP growth for 2004. Stabilization of the political situation (after President Chavez's success in the recent recall election) and the benefits of higher world oil prices should help keep the Venezuelan economy growing at 4 percent or better for 2005.

Elsewhere in Latin America, the economies of Chile, Colombia, and Peru all appear to be doing reasonably well, with growth rates likely to be in the 4 to 5 percent range for both this year and next. With a couple of exceptions (notably the Dominican Republic in 2004) the smaller economies of the region also appear to be doing reasonably well-and a little better than expected in April. Thus, for Latin America as a whole, my forecast for 2004 is raised from 3½ to 5 percent. However, because 2005 will not see such dramatic gains from bounce-backs from recent economic crises (as we are now seeing in Argentina, Uruguay, and Venezuela), the growth forecast falls back modestly to 4 percent.

Asia

In Japan, strong results for the final quarter of 2003 and the first quarter of 2004 will likely generate year-over-year real GDP growth for 2004 that is about 4 percent. The slowing of growth in the Japanese economy since early this year, however, suggests that my April forecast of 3 percent real GDP growth on a Q4/Q4 basis is still about on track.

For 2005, I retain a somewhat more optimistic view than most forecasters, with a projection of 2½ percent real GDP growth on both a year-over-year and Q4/Q4 basis. This slowdown from the recent more rapid pace of Japanese economic growth reflects slower growth in the United States and emerging Asia, along with the effect of higher oil prices, will impact the Japanese economy going forward. But my forecast for 2005 is above that of most other forecasters because I continue to believe that there remains considerable slack in the Japanese economy and that recovery of domestic demand will help to take up this slack gradually over the next two or three years. With deflation apparently ending, but with no threat that inflation will soon become a problem, I expect that the continuation of a very accommodative monetary policy will help underpin continued Japanese economic recovery.

The Chinese economy continued to surge through the first quarter of 2004, despite (somewhat timid) efforts of the authorities to cool the advance. In the second quarter, more determined measures appear to have contributed to a substantial economic slowdown on a quarter-on-quarter basis-although year-on-year growth remained about 9½ percent.

For 2004 as a whole, it now appears that very strong growth in the second half of 2003 and in early 2004 warrants a slight increase in my year-over-year forecast, from 8½ to 8¾ percent, notwithstanding the recent slowdown. In contrast, for 2005, I cut my forecast modestly from 7½ to 7 percent in recognition of the policy efforts of the Chinese authorities, of evidence of a build-up of inventories, of the likely impact of higher oil prices, and of the unsustainability of recent exceptionally high levels of investment in China.

In India, a favorable monsoon last year is contributing to strong year-over-year growth for 2004, and the optimism of my April forecast of 7¾ percent growth is revised down only slightly to 7½ percent. Less favorable weather this year, however, appears likely to dent economic performance (on a year-over-year basis) for 2005, yielding a slight reduction in my earlier forecast of 6½ percent real GDP growth. The moderately stimulative fiscal policy of the new Indian government and strong export performance should help avoid a larger slowdown.

In Korea, the hangover effects from the collapse of the consumer credit boom and the impact of higher oil prices appear likely to keep growth this year closer to 5 percent than 6 percent. The slowdown in the United States, Japan, and emerging Asia suggest that growth for next year will also be only about 5 percent-despite some easing of monetary policy and efforts at fiscal stimulus.

Elsewhere in emerging Asia, the picture for 2004 is brighter. Hong Kong, Malaysia, Taiwan, Thailand, and especially Singapore are all doing better than earlier anticipated. Taking account of somewhat weaker than expected performance for Korea, the result is a slight upgrade of the 2004 forecast for emerging Asia other than China and India-from 6 to 6¼ percent. For 2005, however, I hold to the view that there will be a meaningful slowdown of growth in other emerging Asia. Indeed, with growth slowing somewhat more than earlier anticipated in the United States, Japan, and China, and with higher oil prices having negative impacts on most Asian emerging-market economies, I expect that growth next year will slow to 5 percent-still a quite respectable performance.

Europe

Thanks to modestly stronger performances in France, the United Kingdom, and most of the smaller countries, Western Europe appears to be growing marginally more rapidly than was expected in April-with 2¼ percent growth now forecast for 2004 compared with an April forecast of 2 percent. Germany continues to lag most other countries in the region, but growth there now seems likely to at least meet my April forecast of 1½ percent-thus leaving Italy as the slowest growing major European economy for 2004. However, recent optimism that the euro area may grow more than 2 percent this year seems to ignore the likely impact of higher oil prices and the slowdown in the United States and Asia.

Higher oil prices will have some negative impact on growth in Western Europe in 2005, even if the effect is likely to be less than in the United States. On the other side, the short-term negative effects of the strengthening of the euro against virtually all other currencies (especially the US dollar) during 2003 should be largely absorbed by early next year; and the euro has actually depreciated somewhat from its peak early this year. Meanwhile, consumer and business confidence have been staging gradual (if somewhat hesitant) recoveries-suggesting that domestic demand can probably sustain continued modest real GDP growth.

Unlike virtually all other industrial-country central banks (except the Bank of Japan), the European Central Bank (ECB) wisely has not yet started to raise its policy interest rate. Despite increases of inflation rates (primarily related to higher energy prices) to near the ECB's desired ceiling, it seems likely that the ECB will continue to lag behind most other central banks in the present cycle of monetary tightening. Thus, monetary policy will continue to support economic growth in most of Western Europe. Wisely or unwisely, fiscal policy may also play a modest role in this regard. All things considered, Western Europe is the one major region of the world economy where growth may be slightly stronger in 2005.
In Central and Eastern Europe, economic growth this year has exceeded earlier expectations in most if not all countries. Higher world oil prices have helped boost growth in Russia (the region's largest economy) and among the other energy exporters, Kazakhstan and Azerbaijan. The Turkish economy has proved surprisingly buoyant despite higher oil import costs; and growth has also picked up more than expected in Poland and (to a lesser extent) in Hungary. The overall result is that growth in the region this year now appears likely to reach at least 5½ percent. For 2005, a modest slowdown of growth to about 5 percent is likely as the temporary factors that have recently helped boost growth in several countries wear off.

The Middle East and Africa

Higher oil prices have helped boost growth in the oil-exporting countries of the Middle East and Africa, while strong prices for many other commodities have helped a number of other commodity-exporting countries. Meanwhile, with the exception of Iraq, Arab Palestine, and a couple of African countries, armed conflicts and social turmoil have generally had less of a depressing effect on economic activity than has typically been the case in these regions. The result will surely be that in 2004 both the Middle East and Africa will enjoy the strongest economic growth that they have seen in many years.

Table 1 Global growth prospects: Assessment as of September 7, 2004 (annualized percentage real GDP growth rates, year over year [Yr/Yr] and fourth quarter to Fourth quarter [Q4/Q4])