OECD ECONOMIC OUTLOOK PRELIMINARY EDITION
EDITORIAL - AFTER THE STORM?
28 May 2008, Jørgen Elmeskov, Acting Head, Economics Department
Several quarters of weak growth lie ahead for most OECD economies. At the same time, headline inflation could remain high for some time to come. This scenario is the combined outcome of financial market turmoil, cooling housing markets and sharply higher commodity prices. The projections in this OECD Economic Outlook carry both upside and downside risks and embody the following main features:
• US activity is essentially flat through 2008 and then picks up thereafter as housing adjustment ends, credit conditions normalise and the effects of past monetary ease are felt. With substantial capacity slack and under the assumption of unchanged commodity prices, inflation moderates significantly. Robust export growth, on the back of recent dollar depreciation, helps to narrow the external deficit to around 4½ per cent of GDP next year.
• Euro area activity is restrained through the current year by tighter credit, squeezed real incomes, lower export market growth and market share losses. Growth gradually recovers as these factors fade, though falling housing investment remains a drag throughout. Despite currency appreciation inflationary pressures are strong and, with capacity use moving just slightly below its normal level, it is only towards the end of the projection period that inflation reverts to 2%.
• Japan has been less directly affected by financial turmoil but growth is held back in the near term by slower export growth, weak household incomes and some hesitancy on the part of firms to invest. As growth regains momentum, inflation also gradually moves up to reach a rate around ½ per cent.
The current economic situation is particularly unsettled and the distribution of risk around the projections is wide. In this environment, economic policy in OECD countries needs to take into account the growing importance of developments in non-OECD economies; the influences of higher energy and credit costs on the supply side of OECD economies; the possibility of upward drift in inflation expectations; and the uncertainty as to the effects of financial market developments on growth and inflation.
Globalisation was an important driver of the economic cycle on the way up as non-OECD economies exported both cheap manufactured products and surplus saving, helping to keep OECD interest rates low and thereby boosting asset demand and prices. Currently, robust non-OECD growth is an important factor behind high commodity prices. And, going forward, continued rapid import growth in non-OECD countries will help to cushion activity in the OECD area. At the same time, buoyant non-OECD demand is leading to inflationary pressure in these countries and sustains tensions in commodity markets.
Macroeconomic policy setting, and in particular monetary policy, in OECD countries needs to take into account that non-OECD countries are likely to be an important source of demand at the same time as they are likely to be a less important source of disinflation than previously.
1
OECD ECONOMIC OUTLOOK PRELIMINARY EDITION
Macroeconomic policy is also faced with a more hazy picture of OECD economies’ supply capacity than previously. Both globalisation and structural reform have boosted potential growth rates in the past and will hopefully continue to do so. But sharply higher energy prices and higher costs of capital as a result of financial market developments could sap potential growth. The chapter on supply side uncertainties in this Economic Outlook provides some illustrative calculations of these effects. While such quantifications are inherently uncertain, macroeconomic policy needs to be alert to the possibility that capacity limits could be tighter than posited.
Signs that inflation expectations could be drifting up also call for caution. Well-anchored inflation expectations are a crucial policy asset earned, in many cases, through painful disinflation in past decades. Confidence in price stability can be enhanced through various institutional arrangements coupled with careful communication but the ultimate confidence-enhancing measure is to actually deliver.
Financial market influences on growth remain hard to gauge. The odds have improved that financial market dislocation has passed its peak, but this is far from a foregone conclusion. And even if true, the effects on growth are likely to linger. Uncertainty is compounded by the likely feed-back from a weaker growth environment on financial markets and by the fact that problems at financial institutions can be resolved in different ways. In this regard, it is desirable for capital deficiency to be addressed through the injection of new capital and asset disposal rather than through credit compression. While a slower than projected normalisation of financial markets cannot be excluded, nor can a more rapid restoration, especially if improved confidence were to create a positive feed-back between financial asset prices and institutions’ balance sheets. Central banks need to stand ready to deal with both eventualities.
Apart from dealing with the fall-out on demand from current financial market distress, it will be necessary to re-visit the prudential and supervisory framework for financial markets. The Financial Stability Forum has recently provided directions for change in these areas and efforts towards implementation are in some cases already underway. It will be important to carry through with the required reforms, also when the memory of recent turmoil becomes more distant and those subject to tighter regulation more likely to resist. At the same time, regulatory overkill needs to be avoided. Many recent innovations in financial markets have the capacity to improve welfare, when appropriately harnessed.
It also needs to be considered whether and how the tendency for financial markets to generate cycles can best be addressed. This may involve both regulatory initiatives to attempt to damp inherent cyclicality as well as a reconsideration of monetary policy conduct. Dynamic provisioning and reserve requirements are some of the instruments that may help smooth credit cycles and increase resilience of the financial sector but they are not without drawbacks. Concerning monetary policy, it may not be desirable nor feasible to prick bubbles, but greater symmetry in the response to credit booms and busts may be useful.
As regards fiscal policy, the United States has introduced temporary tax rebates that seem to be appropriately timed and targeted and therefore stand a good chance of providing needed support to activity. The issue of fiscal stimulus has also been broached for other OECD regions but, in general, the case for such initiatives is weak. Inflation pressures in the euro area are such that any stimulus might have to be offset by monetary policy and, in any case, automatic fiscal stabilisers are much stronger than in the United States. In Japan, the fiscal situation does not allow fiscal expansion and the economy is anyway less directly affected by financial turmoil than other OECD countries.
Much higher food and energy prices are leading to demands for offsetting policy action. Such demands ought to be resisted. Only by allowing the right price signals to affect demand and supply can better balance be established in these markets. Concerns for living standards among those on low incomes are better addressed through an appropriately designed tax and social transfer system. 2
OECD ECONOMIC OUTLOOK PRELIMINARY EDITION
3
Overall, OECD economies have been hit by strong gales over the recent past and it will take time and well-judged policies to get back on course. Nonetheless, it is a tribute to the effects of past structural reform and well-honed macro-policy frameworks that the effects of this near-perfect storm have not been worse. This underlines the need to persevere with such policies.
28 May 2008
Jørgen Elmeskov
Acting Head, Economics Department
EDITORIAL - AFTER THE STORM?
28 May 2008, Jørgen Elmeskov, Acting Head, Economics Department
Several quarters of weak growth lie ahead for most OECD economies. At the same time, headline inflation could remain high for some time to come. This scenario is the combined outcome of financial market turmoil, cooling housing markets and sharply higher commodity prices. The projections in this OECD Economic Outlook carry both upside and downside risks and embody the following main features:
• US activity is essentially flat through 2008 and then picks up thereafter as housing adjustment ends, credit conditions normalise and the effects of past monetary ease are felt. With substantial capacity slack and under the assumption of unchanged commodity prices, inflation moderates significantly. Robust export growth, on the back of recent dollar depreciation, helps to narrow the external deficit to around 4½ per cent of GDP next year.
• Euro area activity is restrained through the current year by tighter credit, squeezed real incomes, lower export market growth and market share losses. Growth gradually recovers as these factors fade, though falling housing investment remains a drag throughout. Despite currency appreciation inflationary pressures are strong and, with capacity use moving just slightly below its normal level, it is only towards the end of the projection period that inflation reverts to 2%.
• Japan has been less directly affected by financial turmoil but growth is held back in the near term by slower export growth, weak household incomes and some hesitancy on the part of firms to invest. As growth regains momentum, inflation also gradually moves up to reach a rate around ½ per cent.
The current economic situation is particularly unsettled and the distribution of risk around the projections is wide. In this environment, economic policy in OECD countries needs to take into account the growing importance of developments in non-OECD economies; the influences of higher energy and credit costs on the supply side of OECD economies; the possibility of upward drift in inflation expectations; and the uncertainty as to the effects of financial market developments on growth and inflation.
Globalisation was an important driver of the economic cycle on the way up as non-OECD economies exported both cheap manufactured products and surplus saving, helping to keep OECD interest rates low and thereby boosting asset demand and prices. Currently, robust non-OECD growth is an important factor behind high commodity prices. And, going forward, continued rapid import growth in non-OECD countries will help to cushion activity in the OECD area. At the same time, buoyant non-OECD demand is leading to inflationary pressure in these countries and sustains tensions in commodity markets.
Macroeconomic policy setting, and in particular monetary policy, in OECD countries needs to take into account that non-OECD countries are likely to be an important source of demand at the same time as they are likely to be a less important source of disinflation than previously.
1
OECD ECONOMIC OUTLOOK PRELIMINARY EDITION
Macroeconomic policy is also faced with a more hazy picture of OECD economies’ supply capacity than previously. Both globalisation and structural reform have boosted potential growth rates in the past and will hopefully continue to do so. But sharply higher energy prices and higher costs of capital as a result of financial market developments could sap potential growth. The chapter on supply side uncertainties in this Economic Outlook provides some illustrative calculations of these effects. While such quantifications are inherently uncertain, macroeconomic policy needs to be alert to the possibility that capacity limits could be tighter than posited.
Signs that inflation expectations could be drifting up also call for caution. Well-anchored inflation expectations are a crucial policy asset earned, in many cases, through painful disinflation in past decades. Confidence in price stability can be enhanced through various institutional arrangements coupled with careful communication but the ultimate confidence-enhancing measure is to actually deliver.
Financial market influences on growth remain hard to gauge. The odds have improved that financial market dislocation has passed its peak, but this is far from a foregone conclusion. And even if true, the effects on growth are likely to linger. Uncertainty is compounded by the likely feed-back from a weaker growth environment on financial markets and by the fact that problems at financial institutions can be resolved in different ways. In this regard, it is desirable for capital deficiency to be addressed through the injection of new capital and asset disposal rather than through credit compression. While a slower than projected normalisation of financial markets cannot be excluded, nor can a more rapid restoration, especially if improved confidence were to create a positive feed-back between financial asset prices and institutions’ balance sheets. Central banks need to stand ready to deal with both eventualities.
Apart from dealing with the fall-out on demand from current financial market distress, it will be necessary to re-visit the prudential and supervisory framework for financial markets. The Financial Stability Forum has recently provided directions for change in these areas and efforts towards implementation are in some cases already underway. It will be important to carry through with the required reforms, also when the memory of recent turmoil becomes more distant and those subject to tighter regulation more likely to resist. At the same time, regulatory overkill needs to be avoided. Many recent innovations in financial markets have the capacity to improve welfare, when appropriately harnessed.
It also needs to be considered whether and how the tendency for financial markets to generate cycles can best be addressed. This may involve both regulatory initiatives to attempt to damp inherent cyclicality as well as a reconsideration of monetary policy conduct. Dynamic provisioning and reserve requirements are some of the instruments that may help smooth credit cycles and increase resilience of the financial sector but they are not without drawbacks. Concerning monetary policy, it may not be desirable nor feasible to prick bubbles, but greater symmetry in the response to credit booms and busts may be useful.
As regards fiscal policy, the United States has introduced temporary tax rebates that seem to be appropriately timed and targeted and therefore stand a good chance of providing needed support to activity. The issue of fiscal stimulus has also been broached for other OECD regions but, in general, the case for such initiatives is weak. Inflation pressures in the euro area are such that any stimulus might have to be offset by monetary policy and, in any case, automatic fiscal stabilisers are much stronger than in the United States. In Japan, the fiscal situation does not allow fiscal expansion and the economy is anyway less directly affected by financial turmoil than other OECD countries.
Much higher food and energy prices are leading to demands for offsetting policy action. Such demands ought to be resisted. Only by allowing the right price signals to affect demand and supply can better balance be established in these markets. Concerns for living standards among those on low incomes are better addressed through an appropriately designed tax and social transfer system. 2
OECD ECONOMIC OUTLOOK PRELIMINARY EDITION
3
Overall, OECD economies have been hit by strong gales over the recent past and it will take time and well-judged policies to get back on course. Nonetheless, it is a tribute to the effects of past structural reform and well-honed macro-policy frameworks that the effects of this near-perfect storm have not been worse. This underlines the need to persevere with such policies.
28 May 2008
Jørgen Elmeskov
Acting Head, Economics Department
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