United States of America: The sharp reduction in energy costs is likely to boost consumer spending and economic activity in the fourth quarter despite continued weakness in the housing market and in autoproduction. Latest data suggests that the US economy is experiencing moderately lower growthbut generally steady growth in household incomes should keep the rate of growth of GDP in theregion of 2.5%. The September employment report was mixed. Although the gain in non-farmpayrolls was low, the data for August was revised up and the unemployment rate dropped to 4.6%.Wage pressures eased slightly and the underlying trend in labour demand is probably downward.Surveys of manufacturing and non-manufacturing confidence indicate that growth slowed in thethird quarter. The index of service sector activity in September was the lowest since 2003 and themoderating trend in new orders for manufacturing suggests that growth in industrial productionwill slow in the fourth quarter as producers adjust stock levels. Price pressures are clearly easing.Input costs fell in September and fewer capacity pressures were reported. Inflation expectationsbenefited from the drop in energy prices and lower gasoline prices may help increase auto sales.
Looking to 2007, the key issue will be the extent to which the correction in the US housingmarket impacts the rest of the economy where, to date, performance has been steady. If thehousing weakness is contained and the reduction in energy costs is sustained, the boost to realincomes and consumer spending could lead to rather stronger growth in GDP in the first quarter ofnext year. Latest data shows that both housing permits and starts are falling rapidly but previoustrends suggest that the number of permits may stabilize in the near future. In this case the decline inpermits already seen suggest a significant near-term downshifting in residential investment buthousing-related GDP growth should gradually climb back towards trend during the course of 2007.
Recent statements from the US Federal Reserve suggest that the central bank remains concernedregarding the inflationary pressures in the US economy and that higher interest rates cannot beruled out. The balance of opinion in financial market analysts has moved to anticipate reductionsin US interest rates next year but much depends on the continued path of energy costs and thelevel of spare capacity in the economy. On balance the Federal Reserve will probably becautious and wait to assess the impact of any bounce in consumer spending on labour and inputcost indicators for the economy as a whole. Certainly the fall in energy prices will have amarked effect on headline consumer prices in the coming months but the trend of coreinflation will be the main focus of the US central bank..
Overall GDP growth is expected to be less than 3% in the second half of this year. The autoindustry, in particular, is planning sharp cuts in output in order to reduce inventory levels. In2007 GDP growth is expected to fall further to 2.6% as lower growth of businessinvestment, exports and government spending takes effect. Revised second quarter datashowed surprise stagnation in corporate profits and a fall in companies’ investment in newequipment and software. Next year may see an end to the strong growth in investment recordedsince 2004.
A particular uncertainty is the contribution of the US stockmarket to the growth of theeconomy. In recent weeks the prospect of steady, non-inflationary growth has pushedshare prices to new highs. This has offset much of the negative impact on household wealthof the fall in house prices. It remains to be seen whether the stock market can continue to makeprogress in 2007 as GDP growth slows and wage incomes continue to accelerate. If thestockmarket were to consolidate and house prices to stabilize or fall, asset markets in 2007 mightno longer provide savings for households and consumers will have to begin to save more of theircurrent income. An increase in the savings rate means that the growth of consumer spending willhave to fall below the growth of real incomes. If spending were to grow by less than 2.8% in2007 this would be the weakest performance since the recession year of 2001.
There has been little change in the strong momentum of Japanese companies in recent months.Manufacturing activity remained firm in the third quarter and industrial production probably roseby at least 4% on an annualized basis. The latest Bank of Japan Tankan report indicated thatbusiness sentiment remained optimistic in September. The index of current businessconditions was stronger than expected and the outlook for December was also healthy.Exporters have become more optimistic for sales growth with large manufacturers reporting aparticularly good outlook for overseas demand. This background continues to support highlevels of capital expenditure as firms predict a shortage of production capacity. Earlier in theyear capital expenditure had been expected to level off but this now seems unlikely and businessinvestment spending should grow by at least 6% in the final quarter of the year.
Despite this encouraging performance, personal consumption in Japan weakened in the summer.The lower growth of earnings and the rise in energy prices depressed consumer spending in thethird quarter. Domestic car sales have been weak while sales of clothes, footwear and consumerdurables have softened. Most of this weakness was in July and August while an improvementwas noted in September. Overall consumer spending growth was probably not much above1% in the third quarter which will have reduced GDP growth to below 3% following thelow 1% recorded in the second quarter.
The underlying trend in inflation has not changed as dramatically as it initially appeared whenthe rebased data appeared in August. The larger-than-expected revision in core inflation to 0.2%in July was due to a new treatment of mobile phone charges. In August the CPI excluding foodand energy fell by 0.4%. It is likely that core CPI inflation will rebound to 0.2-0.3% by the endof the year although this may be moderated if consumer spending continues to be weak. A lowpositive rate of inflation will probably be maintained through 2007 reflecting the gradualabsorption of spare capacity in the economy.
The Bank of Japan appears to attach more weight to the optimistic Tankan survey than theconsumer spending data. On balance it appears that a rise in interest rates in December isnow more likely although lower energy costs and the depressed trend of unit labour costs meanthat the Bank will be under little pressure to raise rates. The expected moderation in worldeconomic activity may also have its effect on Japan in the final quarter of this year althoughthere is little evidence of export weakness thus far. One consequence of the higher input costsfaced by companies seems to be a greater determination to control labour costs and this shoulddampen inflationary expectations in the household sector. The yen has continued to be weakdespite the economic recovery and this factor may push the Bank of Japan to act. IfJapanese interest rates remain very low next year and the yen remains depressed in relation tothe US dollar this may impact other Asian currencies which may prefer not to appreciate againstthe yen. Weak Asian currencies in 2007 may inhibit moves to narrow trade imbalances betweenthe US and Asia, aggravating political pressure for action on trade flows.
There is no doubt that the first half of 2006 was a strong period of growth for the Euro-zone.On balance survey evidence suggests that growth remained above trend in the third quarteralthough below the excellent 3.6% achieved in the second quarter. The EC sentimentindicator, which incorporates expectations and the current assessment of participants,continued to move higher. Retail sales in the Euro-zone rose by 2.4% in August in comparisonto 2005 levels. Other indicators, such as the Purchasing Managers Index (PMI), suggest thatgrowth peaked in the second quarter. On average the third quarter PMI was down 1.5 pointsfrom its second quarter level. Industrial production trends showed no clear pattern. Julyindustrial production in the Euro-zone was only 0.1% above the second quarter average andcar registrations fell but August showed a clear improvement as industrial production rose by0.8% in France and a strong 1.9% in Germany. Overall it appears that Euro-zone GDP rose byabout 2.5% on an annualized basis in the third quarter. The implication of the survey evidencefor the fourth quarter is that growth will continue at a fairly solid pace but that a slowdown isclearly on the horizon. Expectations have conclusively turned down and this probably reflectsrising concerns about the future development of the US economy. In Germany, an additionalconcern is the lack of progress regarding political reforms.
Beyond 2006 the outlook is much more uncertain. As expected the European Central Bankraised interest rates to 3¼% in the first week of October. Of greater significance it appearedfrom the ECB press conference that a further hike is very likely to follow in December and the Bank has not ruled out further increases in 2007. A particular concern is the impact of thestronger growth this year on wage costs. With monetary policy tightening further, an expectedeasing in global growth and a significant tightening in fiscal policy, Euro-zone growth isexpected to fall to 1.6% in 2007. The policy outlook has been obscured by the recent fall inenergy costs. The ‘flash’ estimate of Euro-zone inflation fell to 1.8% in September, sharplydown from the 2.3% recorded in August although the core rate, which excludes food andenergy costs, probably rose in the month. The financial futures markets anticipate that thethree month rate of interest will be 3.67% by December 2006 and 3.8% by March 2007 whichshould mark the end of the upward rate adjustment process. By mid-2007 a slower pace ofgrowth should allow the Bank to abstain from much further tightening and the peak of officialinterest rates should be no higher than 3¾ - 4%.
In 2006, the Euro-zone will benefit again from substantial growth in exports but in 2007 thestronger value of the euro should restrain growth. Tighter monetary conditions and slowerworld growth will impact the Euro-zone. Fiscal policy will add a further uncertainty next year.This year the Euro-zone fiscal deficit has improved as a result of the improvement ineconomic growth although the stance of policy has been broadly neutral. In 2007, tighterfiscal policies (notably in Germany and Italy) may reduce Euro-zone growth by as much as0.5% as VAT rates are increased.
Former Soviet Union
According to the Ministry of Economic Development and Trade, GDP grew by 7.4% year-onyearin the second quarter. For the first half of 2006, GDP rose by 6.5% driven byconstruction activity and retail and wholesale trade. The second quarter recovery in economicactivity accelerated in August thanks mainly to buoyant exports. As a result of these trends,GDP is forecast to grow by 6.4% in 2006. Industrial production growth accelerated to 5.6% inAugust and the growth rate for the first eight months of 2006 was 4.3% in comparison to the3.5% recorded in 2005. Construction output increased by 12% in August and growth in theoutput of the extractive sector showed a slight improvement, rising by 1.3% in the first eightmonths of the year. In August inflation rose sharply to 9.7%, despite lower food prices as aresult of higher gasoline and service sector prices. In the first eight months of 2006 the roublehas appreciated by 7.7% in real terms as very high earnings from oil and minerals exportsboosted the currency. The strong performance of energy export revenues has worsened theinflationary situation in Russia as these revenues have enabled further fiscal loosening. Thefirst reading of the 2007 Budget was given in September. Expenditures are projected at 28%higher than the 2006 budget and revenues are expected to rise by 31% although this increasedepends on high estimates of VAT revenues.
Despite tensions which led ultimately to the break-up of the ruling coalition in September thePolish economy continued to perform well in the third quarter. The rate of growth of GDP wasprobably above 5% as a result of solid internal and external demand. Strong wage andemployment growth were behind a surge in private consumption which was also accompaniedby robust growth in fixed investment spending. Net trade also contributed to GDP. In Augustindustrial production rose by 12.5% – exactly in line with the gain for the first eight months ofthe year. Politics also dominated the headlines in Hungary following negative disclosuresrelating to the Prime Minister. It is unclear whether these controversies will have a lastingeffect on policy but in the near term the fiscal reform programme may be weakened. Growthfell to 3.8% in the second quarter as a result of weaker domestic demand and yet furtherpressure on internal spending may follow the fiscal reforms. Exports continue to growstrongly, reflecting the overall recovery in economic activity in Europe this year. Neverthelesstighter monetary conditions, fiscal adjustments and lower exports to the Euro-zone areexpected to lead to much slower growth in 2007. The Czech economy grew by 6.2% in thesecond quarter of the year, down slightly on the 7.1% achieved in the first quarter. The fastestgrowing sector continues to be transport equipment which expanded production by 34% inJuly. The rate of inflation fell to 1.9% in 2005 but has risen to 2.9% in the first eight monthsof this year as a result of higher energy and utility prices. The Czech trade balancedeteriorated slightly in the second quarter as higher exports of road vehicles and parts couldnot match the extra expenditure on imported fuels. The public finance deficit was lower thanexpected at only 2.6% of GDP in 2005. The planned deficit for 2006 is also 2.6% of projectedGDP – well below the Maastricht limit for accession to the Euro-zone – but the deficit outlookfor 2007 is much worse, possibly as high as 4% of GDP, and austerity measures may beneeded to prevent the date for accession to the Euro-zone from slipping beyond 2011.
Intra-regional trade between Asian countries provided an additional impetus to growth as therapid growth of China fed through its regional trading partners. The ASEAN nations are wellplaced to tap into soaring Chinese import demand by providing added value products.Domestic demand of 1.3 billion consumers is the driving force of China’s economic growth.The Chinese government has taken a series of measures in order to stimulate domesticspending, including increasing income of residents, promoting social security, and speedingup public service reforms.
The growth rate of fixed asset investment in China, a major indicator of economic growth,dropped 5.9 percentage points from July to 21.5% in August, the National Bureau of Statisticsreported. The Chinese Central Bank had forecast that the country’s economy is expected togrow by a blistering 10.5% this year but slow down to 9.5% in the first half of next year dueto a combination of factors, including the government’s macro-economic policies to avoidover-heating.
India’s economy expanded 8.9% second quarter, according to the Central StatisticalOrganization in New Delhi, beating economists’ forecasts and adding pressure on the ReserveBank of India RBI to raise its benchmark interest rate for a fourth time this year. Theexpansion of Asia’s fourth-largest economy in the three months to 30 June from a year earlierreached 9.3%.
A new study by the World Bank revealed that recent massive increase in African trade andinvestment by Asia’s two emerging economies, namely China and India, holds great potentialfor growth and job creation in Africa. According to the study, based on new evidence fromthe operations of Chinese and Indian businesses in Africa, Asia now receives 27% of thecontinent’s exports, triple the amount in 1990. Today’s level is almost on par with Africa’sexports to the USA and EU, Africa’s traditional trading partners. Asian exports to Africa aregrowing 18% per year, faster than to any other region in the world. China’s and India’sforeign direct investments in Africa are more modest than trade flows, but they are alsogrowing very rapidly. However, the bank’s study showed that there is still a majorunevenness in the emerging commercial relationships between the two continents. Africanexports to Asia constitute only 1.6% of what Asians buy from the rest of the world, andChina’s and India's African purchases total only 13% of Africa's total exports. Africa accountsonly for 1.8% of the world's foreign direct investment flows, while 20% of the world’s foreigndirect investment goes to East Asia.
OPEC Member Countries
Inflation in OPEC Mideast countries is expected to rise but at a slower pace due to tightermacro-economic policies. In countries with fixed exchange rates, some pickup in inflation isexpected as real exchange rates adjust to higher oil prices. Inflation is expected to be in thelow single digits, aided by an open product and factor market, with the exception of Iraqwhere inflation is expected to remain well in the double digits. Those countries withadjustable exchange rates such as Iran are projected to see double digit inflation.While inflation remained at 14.1%, Iranian central bank stated in a recent bulletin that theIranian economy enjoyed a sustained growth in the five year development plan, which endedMarch 2005. The Iranian government successfully implemented exchange rate unification,integration of the exchange market in the form of inter-bank market, deregulating foreigntrade procedure, establishment of the Oil Stabilization Fund and improvements in thecomposition of external debt.
Oil prices, the US dollar and inflation
The euro strengthened slightly in August to $1.27 as it became clear that the EuropeanCentral Bank was very likely to raise interest rates further in October and this parity wasmaintained throughout September. Low interest rates continued to put pressure on the yen andthe dollar rose to over ¥117. In September the dollar rose by 0.3% against the euro fell by 1%against the British pound, gained 1.1% against the Swiss franc and was up 2.1% versus theyen.
In September the OPEC Reference Basket fell to $59.34/b from $68.81/b in August. In realterms (base July 1990=100), after accounting for inflation and currency fluctuations, theBasket price fell by 13.7% to $40.45/b from $46.86/b. The value of the dollar rose by 0.3% asmeasured by the import-weighted modified Geneva I +US dollar basket.