Each November and May the Organization for Economic Cooperation and Development (OECD) issues economic forecasts for its 30 members and selected emerging economies. In May, prior forecasts for 2007, 2008 and 2009 were updated. In its summary, the OECD said that the advanced economies had dodged a bullet from the financial market implosion remarkably well. And while the OECD predicted recovery, they said the pace would be slower than originally estimated in November and the revised forecasts reflected this slower pace. At the same time they said more expensive energy and food will squeeze real incomes and raise prices across the developed world.

The OECD said that there was a potential for an unexpectedly rapid recovery among the 30 OECD member states if financial conditions improve, lowering the current high price of credit and feeding through to the real economy. While the odds had improved that the worst was over in financial markets, policy makers — both in setting interest rates and government budgets — should be careful not to provide too much stimulus for fear of allowing inflation to take root.

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.

OECD noted that well-anchored inflation expectations have given central banks the flexibility to respond to the financial turmoil through the 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.

After maintaining its 2007 forecast at 2.7 percent for its 30 members, OECD cut its 2008 forecasts to an average of 1.8 percent from 2.3 percent in November. 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. The organization also revised its 2009 expectations downward from 2.4 percent in 2009 to 1.7 percent.

European growth holds up

Growth in the 15 member European Monetary Union is expected to moderate this year with a trough in the second quarter. Output growth has been slowed by a combination of tighter financial conditions, higher inflation and weaker housing market activity. Growth in 2008 is expected to drop below potential before picking up slowly through 2009 as financial headwinds dissipate and the external environment improves. Domestic demand should be underpinned by continued job creation and a modest pick up in wage growth. 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. Unlike other major central banks, the ECB has steadfastly kept its eye on its inflation target mandate and has not followed other central banks as they lowered their policy interest rates. Rather, it has kept its key interest rate at 4 percent. OECD’s projections for the EMU are for GDP to increase 2.6 percent in 2007 but slow to 1.7 percent in 2008 and 1.4 percent in 2009.

Germany has once again proven itself to be the EMU engine of growth. Following weaker activity at the end of 2007, growth picked up strongly at the beginning of the current year. So far, there is little evidence of significant adverse effects on the real economy coming from the financial turmoil, the strong euro or high commodity prices. But because of a cooling in exports, growth is expected to ease over the remainder of this year before returning to trend next year. Private consumption is projected to pick up, reflecting the significant growth in disposable income. But as the labor market tightens, the period of wage moderation is ending. Germany is projected to grow 2.6 percent in 2007 but slow to 1.9 percent in 2008 and 1.1 percent in 2009.

Growth picked up in the first quarter of 2008 in France, although activity is thought to be softening in the second quarter and is projected to remain weak in the rest of 2008 and into early 2009. The slowdown should help limit further increases in wages and prices in the face of recent food and energy shocks. The shortfall in the general government financial balance may widen in 2008 before stabilizing in 2009. After stimulating 2008 demand through tax cuts, fiscal policy is set to tighten in 2009. However, a significant and sustainable decline of the budget deficit will require far more substantial reductions in public spending than those announced to date. France is projected to grow 2.1 percent in 2007, 1.8 percent in 2008 and 1.5 percent in 2009.

Economic activity in Italy has stalled since the first half of 2007. The weakening external environment along with the effects from tighter credit conditions are expected to constrain growth to below its potential rate of around 1.25 percent this year, while unemployment may rise again. The recent surge in consumer price inflation should fade towards the end of 2008. Italy continues to lag other EMU member states. Growth is projected to be 1.4 percent in 2007 and 0.5 percent in 2008 and 0.9 percent in 2009.

Growth in the United Kingdom has slowed from an above trend pace throughout 2007 and is expected to continue to do so over coming quarters as both investment and consumer demand are damped by tight credit conditions and housing market weakness. Consumer price inflation has accelerated in recent months and is expected to rise further to above 3.5 percent later this year before falling back to close to the 2 percent inflation target during 2009. The OECD recommends that the Bank of England should leave policy interest rates on hold in the short term in order to ensure that high inflation expectations do not become embedded. However, some further easing in policy rates is likely to be required further ahead to avoid a significant undershooting of the target in the medium term as the economy slows. After impressive 3.0 percent growth in 2007, GDP is expected to slow to below trend 1.8 percent growth in 2008 and 1.4 percent in 2009.

Asia/Pacific has not decoupled

After reaching 4.1 percent in 2007, Australian economic activity is likely to slow to below 3 percent in 2008 and 2009 because of tighter financial conditions and the worsening external environment. This should ease pressures on the labor market and bring inflation down to under 3 percent by the end of 2009. To avoid rising inflation expectations, monetary policy needs to be kept tight until domestic demand and price pressures have moderated sufficiently. In this context, the stabilizing role that fiscal policy should play is welcome. GDP is projected to grow 4.1 percent in 2007 and 2.9 percent in 2007 and 2.7 percent in 2008.

Although growth is slowing in Japan, wage gains and a rebound in housing investment should help sustain the expansion in 2008. Thanks to soaring import prices, headline inflation as measured by the consumer price index has risen to about 1 percent. But core inflation (excluding food and energy) is around zero and is expected to pick up only slowly. OECD suggests that the Bank of Japan should not raise its 0.5 percent policy interest rate while underlying inflation remains close to zero. Structural reforms are needed to boost productivity, particularly in the service sector, which would help maintain improvements in living standards despite a shrinking working-age population. Japan is projected to grow at 2.1 percent in 2007, 1.7 percent in 2008 and 1.5 percent in 2009.

North America

The good news from the OECD’s forecasts is that the United States will escape a recession in 2008 despite the strong headwinds which are exerting a sizeable drag on activity. The financial crisis and resulting credit squeeze and declining house prices are putting pressure on household wealth while sharp commodity price increases are eroding workers’ disposable incomes. After stalling this year, real GDP growth should gradually return to potential in 2009 as macroeconomic policy takes hold. Other pluses will be a dynamic external sector which will continue to benefit from the growth of world trade and the weakening of the dollar. OECD suggests that monetary policy should be maintained at the current accommodative stance until the recovery has taken hold, but interest rates should be raised promptly when conditions normalize. The U.S. is projected to grow 2.2 percent in 2007, 1.2 percent in 2008 and 1.1 percent in 2009.

Canadian economic growth decelerated sharply late in 2007 mainly because of faltering exports and manufacturing output. Growth is projected to remain weak until spring 2009 as U.S. demand stagnates. The current account may dip deeper into deficit, and the general government fiscal balance may show a small deficit as well as both tax cuts and the business cycle eat into government revenues. Economic growth is expected to bounce back in 2009 when credit market difficulties are worked out and the U.S. economy recovers. Canada is projected to grow 2.7 percent in 2007, 1.2 percent in 2008 and 2.0 percent in 2009.

BRICs — can they lead the way?

BRIC is an acronym for the economies of Brazil, Russia, India and China combined. The general consensus is that the term was first prominently used in a Goldman Sachs report from 2003, which speculated that by 2050 these four economies would be wealthier than most of the current major economic powers. OECD includes them in their semi-annual forecasts.

In 2007, Brazilian GDP grew at its fastest pace since 2004, but is expected to slow going forward. Private consumption continues to be the main driver aided by improving labor markets and robust credit creation. Investment rebounded and this helped to alleviate capacity constraints. Exports are performing well, despite a strong currency (the real). Yet the trade surplus is shrinking fast due to increased imports especially of capital goods and intermediate inputs. Energy and food prices have pushed inflation up to well above the 4.5 percent central bank target. The policy mix is shifting towards needed monetary restraint. The official interest rate was raised in April and further tightening is expected in the course of the year. Brazil is projected to grow 5.4 percent in 2007, 4.8 percent in 2008 and 4.5 percent in 2009.

Real activity in the Russian Federation was up in 2007, but is expected to moderate over the projection period as oil and metals prices stabilize around their current high levels. Domestic demand will continue to grow strongly, but net exports are expected to exert a growing drag as imports surge but energy export volume is held back by supply constraints. Inflation is rising, propelled by steep rises in food prices, and validated by the central bank’s unsterilized intervention to manage the exchange rate, which has yielded very rapid money supply growth. Fiscal loosening has added to inflationary pressures and the non-oil fiscal balance continues to deteriorate. Russia is projected to grow 8.1 percent in 2007, 7.5 percent in 2008 and 6.5 percent in 2009.

India’s growth eased in 2007, partly as a result of tighter monetary policy. It would have eased more but for strong farm output. Consumer and wholesale price inflation have picked up, reaching nearly 8 percent by the spring of 2008. With a more restrictive monetary policy stance and a more normal harvest, output growth is projected to gradually slow in 2008 and then to recover slightly in 2009. With world food prices stabilizing, consumer prices are expected to ease back to 5.5 percent in 2009. With higher interest and exchange rates, output growth is projected to gradually slow to 8.7 percent in 2007, 7.8 percent in 2008 and 8.0 percent by 2009.

Economic growth in China has eased slightly to 10.6 percent in the first quarter of 2008 when compared with the same quarter a year ago. It is expected to ease further over the remainder of 2008 and in 2009, as the contribution from net exports declines. Domestic demand growth is projected to remain robust with buoyant incomes driving up consumption. Inflation has increased sharply thanks to soaring food prices. However, it is expected to ease somewhat going forward provided food prices stabilize and offset rising non-agricultural prices. While not mentioned specifically, the May’s Sichuan earthquake will shift some resource utilization toward the recovery and rebuilding effort there. It should be noted that Chinese interest rates are higher than those in the U.S. and further increases would add to the problems of sterilizing capital inflows. 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.

Bottom line

Forecasting can be a perilous occupation at any time, but none more perilous than now. The financial market turmoil and housing related weakness have 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 — although slower than the recent past — 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. 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.