Forecasts are particularly useful at this time of year when investors are planning their strategies for the new year. Each May and November the Organization for Economic Cooperation and Development (OECD) issues economic forecasts for its 30 members and selected emerging economies. Prior forecasts for 2007 and 2008 were updated while a forecast for 2009 was issued for the first time. In its summary, the organization said the world economy is reeling from a succession of blows — financial and housing market turmoil and soaring energy costs — which will cause 2008 growth to slow to its lowest rate in five years. But at the same time, OECD found that its members were in a good position to absorb these shocks thanks to buoyant international trade combined with high employment and high rates of corporate profitability. The main negative risks to the forecasts include a more pronounced or generalized cooling of housing markets than projected, additional turbulence in financial markets and further upward pressures on already high commodity prices.

After maintaining its 2007 forecast at 2.7 percent for its 30 members, OECD cut its 2008 forecasts to an average of 2.3 percent from its May’s 2.7 percent. This would be the weakest performance since 2003 when the world economy grew by just 1.9 percent as it struggled to emerge from the aftermath of the 2000 technology bubble debacle. The organization expects a slight improvement to 2.4 percent in 2009. But it warned that there were big risks to this relatively benign outlook, emanating in particular from housing and financial markets and rising commodity prices. It expects stock markets to remain volatile in the face of repricing of risk caused by tighter credit conditions.

OECD noted that well-anchored inflation expectations have given central banks the flexibility to respond to the financial turmoil through provision of liquidity to interbank markets as well as through lower interest rates than the financial markets previously had expected. Low inflation expectations have helped in the adjustment to higher oil and commodity prices which in turn allowed monetary policy to respond to cooling housing markets where necessary.

It advised the Federal Reserve and the European Central Bank to hold interest rates — even at the price of exacerbating an economic downturn — to avoid higher inflation expectations from taking hold. The report said that “the continued anchoring of inflation expectations cannot be taken for granted.” However, it said that the Bank of England could probably afford to ease monetary policy without risking additional inflationary pressures. Japanese interest rates are expected to stay at 0.5 percent until 2009.

Europe is no longer the weak link

The European Monetary Union (EMU) which encompasses 13 (15 on January 1, 2008) national economies has continued to grow — but at a slower pace than in 2006. A combination of higher interest rates, a strong currency and tighter credit conditions are all expected to dampen activity going forward however. But the outlook remains relatively good with growth projected to return to its potential rate of about 2.0 percent following some near-term weakening. Rising employment and a moderate upturn in wage growth should underpin household incomes and consumption. Inflation is significantly above the European Central Bank’s inflation ceiling of 2 percent thanks to jumps in energy and food prices but is expected to moderate to below 2 percent in 2009. OECD’s projections for the EMU are for GDP to increase 2.6 percent in 2007 but slow to 1.9 percent in 2008 and 2.0 percent in 2009.

German growth picked up in the third quarter of 2007 thanks to strong domestic demand. Going forward, growth is projected to advance at near trend rates during 2008 and 2009. Unemployment is expected to continue to edge down but at a much slower pace than in the recent past. The slower projected expansion largely reflects a diminishing contribution from net exports that is not fully compensated by stronger private consumption. Germany is projected to grow 2.6 percent in 2007 but slow to 1.8 percent in 2008 and 1.6 percent in 2009.

French economic growth slowed in 2007 to a projected rate of 1.9 percent and is expected to remain sluggish in the first half of 2008 and continue at near potential rate in 2009. Job creation will continue but at a slower pace translating to further declines in the unemployment rate. France is projected to grow 1.8 percent in 2008 and 2.0 percent in 2009.

GDP growth in Italy slowed in the first half of 2007 as exports weakened due to the strong euro. OECD projects that growth will be near trend of about 1.5 percent. Unemployment, which continued to fall through the first half of 2007, should decline further but at a slower rate. The recent pick-up in price inflation may persist into 2008 and 2009. Growth is projected to be 1.8 percent in 2007 and 1.3 percent in both 2008 and 2009.

Growth in the United Kingdom has been racing along above its long term growth rate of 2.5 percent. However, growth is anticipated to slow as both investment and consumer demand is expected to weaken thanks to a lethargic housing market combined with tighter credit conditions. Consumer price inflation has dropped sharply after soaring to an annual rate of 3 percent during the summer but needs to be monitored. After impressive 3.1 percent growth in 2007, GDP is expected to slow to below trend 2.0 percent growth in 2008 and 2.4 percent in 2009.

Asia/Pacific — the next engine of growth?

Australia’s economy continues to motor along on almost voracious demand from Asia for its commodities. Despite high interest rates, the bubbly housing and construction markets continue to expand. Inflationary pressures persist even though the Reserve Bank of Australia continues to increase their key interest rate which now stands at 6.75 percent. Third quarter CPI eased to 1.9 percent on the year and just below the RBA’s inflation target zone of 2 to 3 percent after soaring as high as 4.0 percent in previous quarters. Agricultural production has been hard hit by a devastating drought and this, in turn, has affected both prices and growth. Partially offsetting this has been the close to insatiable lust for commodities especially from China. This has boosted demand for Australian products while at the same time the rising Australian dollar has made the country’s exports more expensive especially in the United States. GDP is projected to grow 3.9 percent in 2007 and 3.1 percent in 2007 and in 2008.

Japan’s economic expansion — the longest in Japan’s post-war history — continues despite some deceleration in the pace of growth since early 2007. The weakened expansion remains driven primarily by exports with domestic demand lagging. Deflation continues to be a lingering problem as increases in the CPI have hovered just below zero for most of the year. The Bank of Japan continues to await the arrival of some sort of inflation so that they can normalize interest rates. Exports especially to China have helped ameliorate slower U.S. growth. OECD proffered advice to the Bank of Japan. It said that the BoJ should not increase interest rates until inflation is firmly positive and the risk of renewed deflation is negligible. Japan is projected to grow at 1.9 percent in 2007, 1.6 percent in 2008 and 1.8 percent in 2009.

China’s growth, after moderating in the second half of 2006, has accelerated again. Inflation rate is projected to increase to around 4.5 percent in 2007 and stabilize thereafter as weaker food prices are estimated to offset accelerating non-agricultural prices. Despite continued strong export growth, output is expected to slow in 2008 and 2009 as imports accelerate. Rebalancing growth away from net exports continues to be a key concern, implying that a faster appreciation of the currency should be part of this tightening. OECD forecasts that growth in 2007 will be 11.4 percent and slow to 10.7 percent in 2008 and 10.1 percent in 1009.

India’s economy grew rapidly in the fiscal year 2006 (which ended in March 2007) expanding by 9.4 percent. Strong growth continues thanks to a good performance from the agricultural sector and continued strength of industrial output. In the first half of FY 2007, investment remained buoyant, leading to improvements in the supply potential of the economy. With higher interest and exchange rates, output growth is projected to gradually slow to 8.8 percent in 2007, 8.6 percent in 2008 and 8.4 percent by 2009.

Americas — continued growth

The Canadian economy has been operating above its estimated production potential, but it is expected to decelerate noticeably in the short term as lower external demand and the marked currency appreciation damp activity. While resource rich Western Canada has been booming, manufacturing in the East has suffered a decline in exports thanks to the soaring value of the Canadian dollar. Given international uncertainties, the OECD recommends that the Bank of Canada should hold its interest rate constant for now. As these uncertainties dissipate and recently announced tax cuts take hold, the Bank should stand ready to raise rates with the timing dependent on incoming economic data. Canada is projected to grow 2.6 percent in 2007, 2.4 percent in 2008 and 2.7 percent in 2009.

The United States continues to be dependent on private consumption to keep GDP growth above trend. However, consumption growth could slow due to the residential construction correction, a decline in housing wealth and a weaker labor market going forward. GDP growth is forecast to slow to a pace below its 2.5 percent potential in 2008 and then recover in 2009 — although there are considerable downside risks. OECD expects the U.S. will avoid a recession although growth would slow and unemployment would rise. In May, the OECD had expected the U.S. economy to grow by 2.5 percent in 2008 but it cut that forecast to 2.0 percent. It hoped the Federal Reserve would resist another cut in interest rates until well into 2009 when it expected the housing market to have recovered. Inflationary pressures are expected to remain fairly moderate over the projection period. The U.S. is projected to grow 2.2 percent in 2007, 2.0 percent in 2008 and 2.2 percent in 2009.

Bottom line

Forecasting, especially with so many uncertainties, can be a perilous occupation. The financial market turmoil and housing related weakness has affected each country differently and no doubt will continue to do so in 2008. It is important to note that while growth will slow for the major industrial countries (continued positive growth), none are projected to fall into recession (an absolute decline in growth). OECD acknowledges the risks that abound in the financial markets have caused liquidity to dry up in some markets. Investors continue to worry about who holds risk along with the slow recognition of the magnitude of these losses. As long as the process of re-pricing and loss discovery continues, financial markets are likely to remain a source of vulnerability.

The forecasts are basically good news for investors — the worldwide economy continues to grow albeit at a slower pace, taking pressure off the U.S. economy to be the world’s growth engine. Assuming no further exogenous events, growth should continue on an even keel in 2008. The important thing for Asia and Europe is that they continue to proceed with badly needed structural reforms despite the ongoing recovery. Japan, where growth has weakened perceptively, has to somehow ensure that the deflationary cycle has ended. The country's export induced gains have spread to include investment, employment and to a lesser degree domestic consumption.