EB Report: World Economy Situation

The actual resilience of global aggregate demand has been highlighted recently by the calm with which world markets have navigated through the surge of oil prices, and commodities in general. The most relevant indicator is that US markets have remained extraordinarily buoyant after the resource-rich south was shattered by hurricane Katrina, in a context of already overstretched oil supply. Given the turmoil, worldwide inflationary pressure has remained surprisingly mild. Economists have credited various contemporary international financial system institutions for this success: Enhanced central bank credibility, better management of energy consumption, and modifications in the pattern of global factor allocation, with China (and i.e. Bric countries, Brasil-India-China) keeping prices low by flooding the global marketplace with cheap exports, thereby offsetting the contagious effects of high fuel price levels.

World economic growth is still driven by the US and Asia. As the Japanese recovery continues, decision-makers have started exiting the policy of “quantitative easing” (under which the Bank of Japan has been pumping massive amounts of hot money into the system, in order to steer the island away from deflation), and hawks are already pressing to rise interest rates. Furthermore, emerging markets` bond spread has recently reached a record low, indicating that the current positive financial climate has also drifted along the North-South axis. Obviously enough, this trend of macroeconomic global warming will not stop at the borders of Europe, where sustained low interest rates have kept investment levels rocketing, while significant depreciation of the exchange rate during the past years has opened the way to robust export-led growth. Weak internal demand has therefore been balanced, in part, by the frenzy of oil-exporting countries spending on the continent, the rewards of last year’s spike in oil prices.

In a longer perspective, potential risks are significantly higher and should be seriously considered. Some shadows still loom including the coming cyclical interest rate rise, in the face of the real-estate bubble. A hard landing might trigger both a crunch in credit supply and disposable revenue. Nevertheless, as we have pointed out, inflationary expectations seem to be well-anchored, which might lead to a lower interest rate peak than during the previous cycle. Furthermore, with the US trade deficit expected to reach 7% of GDP by 2007, the sustainability of such global imbalances remains a hot topic of debate among economists. This becomes especially relevant when discussing the possibility of threats to the stability of the greenback, still struggling in the hostile environment of undervalued Asian currencies. Last, but not least, the growth rate in the US can be expected to slow down below its trend after Q2 2006, due to the lagged effects of monetary tightening and unwinding of the current fiscal boost, these stimuli are estimated to account for as much as 1% of GDP. Priorities in the US have apparently switched towards a more conservative fiscal stance, an inflection is expected to take place during this year, provided that the recent talks about enhanced fiscal discipline were not meant to remain mere rhetoric.

Albeit very sound growth forecasts for the coming year, the future performance of the European economy still depends on its ability to undertake and implement the necessary reforms. On energy issues, Europe has proven the advantages of energy-saving policies and regulations in times of turmoil. Recent moves towards a common energy policy, as advocated by EC President Jose Manuel Barroso, could lead the way towards even more independence and bargaining power on energy issues, although the creation of pan-European “multinational champions” might be at odds with some consumer-oriented aspects of antitrust regulation. Some criticism has also been voiced towards the unnecessary interventionism the project would foster. Recent moves towards cross-border acquisition in the sector have been blocked by national governments, unveiling the gap between Mr. Barroso’s and the national governments’ point of view. Other issues essential to the future health of the European economy include pension and labour market reforms. Germany and France have recently taken the first of these much-needed steps, but political consensus might be very difficult to achieve in the short-run, and many difficulties still lie ahead. In these circumstances, a revival of union activism could do much harm to the situation of apparent stability mentioned above.

Although Swiss growth has been hit hard by the surge in oil prices, economic growth in Switzerland has shown exceptional strength in 2005, peaking in the third quarter (with some estimates pointing to an annualised q-o-q rate of 4.3%). Export growth, consumer spending and investment rates are the main factors accounting for the upswing. The dynamism of export activity is mainly due to watches, chemicals and pharmaceuticals, and precision instruments. Therefore, forecasts for 2006 are above the long run level, following the prospects of sustained growth in Europe, an extremely low level of interest rates, both nominal and real, and strongest consumer confidence since 2000 (KOF index). For these reasons many players expect Swiss growth to outperform the Eurozone this year. On the structural side, it is to be noticed that the national government’s fiscal discipline is expected to wipe out our structural deficit by 2007, according to IMF forecasts.

Inflation has remained low, with core inflation estimated at 0.2 % in December 2005. The risk of overheating therefore remains a long way ahead, and, considering strong growth prospects, the Swiss franc is very likely to appreciate during the year. This is a fundamental channel for a small open economy like Switzerland, and the effect of a change in the exchange rate should not be underestimated. The Swiss Franc actually is 3% below its average value to the dollar for 2002-2005, while fundamentals seem to imply as much as a 10 % undervaluation to the Euro. Monetary policy remains accommodating, with real interest rates at 0%. Nevertheless, it is to be reminded that monetary policy needs about two years to unwind its effects, a constraint that might force the SNB to raise interest rates in the coming months.

The actual resilience of global aggregate demand has been highlighted recently by the calm with which world markets have navigated through the surge of oil prices, and commodities in general. The most relevant indicator is that US markets have remained extraordinarily buoyant after the resource-rich south was shattered by hurricane Katrina, in a context of already overstretched oil supply. Given the turmoil, worldwide inflationary pressure has remained surprisingly mild. Economists have credited various contemporary international financial system institutions for this success: Enhanced central bank credibility, better management of energy consumption, and modifications in the pattern of global factor allocation, with China (and i.e. Bric countries, Brasil-India-China) keeping prices low by flooding the global marketplace with cheap exports, thereby offsetting the contagious effects of high fuel price levels.

World economic growth is still driven by the US and Asia. As the Japanese recovery continues, decision-makers have started exiting the policy of “quantitative easing” (under which the Bank of Japan has been pumping massive amounts of hot money into the system, in order to steer the island away from deflation), and hawks are already pressing to rise interest rates. Furthermore, emerging markets` bond spread has recently reached a record low, indicating that the current positive financial climate has also drifted along the North-South axis. Obviously enough, this trend of macroeconomic global warming will not stop at the borders of Europe, where sustained low interest rates have kept investment levels rocketing, while significant depreciation of the exchange rate during the past years has opened the way to robust export-led growth. Weak internal demand has therefore been balanced, in part, by the frenzy of oil-exporting countries spending on the continent, the rewards of last year’s spike in oil prices.

In a longer perspective, potential risks are significantly higher and should be seriously considered. Some shadows still loom including the coming cyclical interest rate rise, in the face of the real-estate bubble. A hard landing might trigger both a crunch in credit supply and disposable revenue. Nevertheless, as we have pointed out, inflationary expectations seem to be well-anchored, which might lead to a lower interest rate peak than during the previous cycle. Furthermore, with the US trade deficit expected to reach 7% of GDP by 2007, the sustainability of such global imbalances remains a hot topic of debate among economists. This becomes especially relevant when discussing the possibility of threats to the stability of the greenback, still struggling in the hostile environment of undervalued Asian currencies. Last, but not least, the growth rate in the US can be expected to slow down below its trend after Q2 2006, due to the lagged effects of monetary tightening and unwinding of the current fiscal boost, these stimuli are estimated to account for as much as 1% of GDP. Priorities in the US have apparently switched towards a more conservative fiscal stance, an inflection is expected to take place during this year, provided that the recent talks about enhanced fiscal discipline were not meant to remain mere rhetoric.

Albeit very sound growth forecasts for the coming year, the future performance of the European economy still depends on its ability to undertake and implement the necessary reforms. On energy issues, Europe has proven the advantages of energy-saving policies and regulations in times of turmoil. Recent moves towards a common energy policy, as advocated by EC President Jose Manuel Barroso, could lead the way towards even more independence and bargaining power on energy issues, although the creation of pan-European “multinational champions” might be at odds with some consumer-oriented aspects of antitrust regulation. Some criticism has also been voiced towards the unnecessary interventionism the project would foster. Recent moves towards cross-border acquisition in the sector have been blocked by national governments, unveiling the gap between Mr. Barroso’s and the national governments’ point of view. Other issues essential to the future health of the European economy include pension and labour market reforms. Germany and France have recently taken the first of these much-needed steps, but political consensus might be very difficult to achieve in the short-run, and many difficulties still lie ahead. In these circumstances, a revival of union activism could do much harm to the situation of apparent stability mentioned above.

Although Swiss growth has been hit hard by the surge in oil prices, economic growth in Switzerland has shown exceptional strength in 2005, peaking in the third quarter (with some estimates pointing to an annualised q-o-q rate of 4.3%). Export growth, consumer spending and investment rates are the main factors accounting for the upswing. The dynamism of export activity is mainly due to watches, chemicals and pharmaceuticals, and precision instruments. Therefore, forecasts for 2006 are above the long run level, following the prospects of sustained growth in Europe, an extremely low level of interest rates, both nominal and real, and strongest consumer confidence since 2000 (KOF index). For these reasons many players expect Swiss growth to outperform the Eurozone this year. On the structural side, it is to be noticed that the national government’s fiscal discipline is expected to wipe out our structural deficit by 2007, according to IMF forecasts.

Inflation has remained low, with core inflation estimated at 0.2 % in December 2005. The risk of overheating therefore remains a long way ahead, and, considering strong growth prospects, the Swiss franc is very likely to appreciate during the year. This is a fundamental channel for a small open economy like Switzerland, and the effect of a change in the exchange rate should not be underestimated. The Swiss Franc actually is 3% below its average value to the dollar for 2002-2005, while fundamentals seem to imply as much as a 10 % undervaluation to the Euro. Monetary policy remains accommodating, with real interest rates at 0%. Nevertheless, it is to be reminded that monetary policy needs about two years to unwind its effects, a constraint that might force the SNB to raise interest rates in the coming months.