I. The Global Economy and the Outlook for the United States and Canada
- International Monetary Fund. Western Hemisphere Dept.
- Published Date:
- November 2007
The global economy continues to grow strongly, although the recent turbulence in financial markets has reduced growth prospects for 2008 and increased downside risks. With vigorous growth in the first half of 2007, world output is now expected to expand by 5.2 percent this year before slowing to 4.8 percent in 2008 (see the October 2007 World Economic Outlook— WEO). As new information about sources of financial weaknesses in industrial economies has emerged, uncertainty about the future path of global economic activity has increased.
(Real GDP; annual percent change)
Source: WEO, October 2007.
The global economy is being supported by a robust expansion in emerging market countries. In particular, emerging Asia is experiencing rapid growth in investment and output, led by China and India, which are expected to grow by 10 percent and 8½ percent, respectively, in 2008. This expansion in emerging market countries is counterbalancing more moderate growth in advanced countries. In the United States, growth is now projected at just below 2 percent in 2008, reflecting the continuing housing correction and the impact of the recent financial turmoil on confidence. The rate of expansion is expected to slow to 2.1 percent in the euro area and 1.7 percent in Japan on weaker external demand and tighter credit conditions. In response to these developments, monetary policy has been eased in the United States and the earlier tightening cycle has been put on hold in the euro area and Japan.
Inflation has edged down in industrial countries, but robust growth and higher commodity prices have led to price pressures in emerging market economies. For the advanced countries as a whole, inflation is expected to fall to 2 percent in 2008, while for developing and emerging markets consumer prices are projected to rise by 5.3 percent in 2008, after increasing by almost 6 percent in 2007. Petroleum price projections underlying the October 2007 WEO have been revised to an annual average of $68 in 2007 and $75 in 2008 and, with supply constraints biting, prices remain volatile. In line with futures markets, prices for metals and agricultural goods are also expected to remain elevated over the next few years, with high food prices reflecting booming biofuel production as well as rising demand from expanding emerging market economies.
Comparison of Commodity Price Projections, April and October 2007 WEOs
Sources: Bloomberg, L.P.; and IMF staff calculations.
Growing concerns about exposure to the U.S. subprime market triggered global financial market turbulence in August that has unwound only partially (Box 1). While stock prices have generally recovered after initial sharp falls, spreads on short-term money market rates and debt instruments have remained elevated despite liquidity injections by major central banks. Industrial country high-yield bonds and asset-backed commercial paper have been hit harder than emerging market debt.
Box 1.Recent Financial Market Turmoil: What Happened, and Why?
Recent financial market liquidity problems can be traced to the search for yield during the low interest rate environment of 2005–06 and a loosening of credit standards, particularly in the U.S. subprime mortgage market. As investors worldwide sought higher yields, U.S. subprime originators faced strong incentives to expand the supply of loans. With many eager to participate in the housing boom but qualified individuals becoming scarcer, there was a rapid loosening of underwriting standards—including inadequate checking of credit quality, higher loan-to-value ratios, and “teaser” initial interest rates on adjustable rate mortgages—whose consequences rating agencies and regulators underestimated. As the U.S. housing market slowed, delinquencies on 2005 and 2006 subprime loans rose rapidly, and the value of the associated asset-backed instruments that were particularly sensitive to market conditions fell precipitously in early 2007.
While some risks were recognized, most observers expected the subprime crisis to be contained, as securitization had dispersed losses across the financial system. As described in Kiff and Mills (2007), the brunt of the crisis was initially borne by subprime lenders themselves, who were often contractually bound to take back loans from securitizers in cases of early payment defaults, and who, in any case, faced radically diminished business prospects as it became clear that the housing market was cooling. Many of these lenders went out of business in early 2007, with little effect on the banking system. There were some signs of concern, based around some hedge funds and other investors with substantial holdings of subprime mortgage-backed securities and the riskier tranches of subprime-based collateralized debt obligations (CDOs), including subsidiaries of Bear Sterns, a large U.S. investment bank.
In August, however, it became clear that the U.S. and European banking systems had significant, although not easily quantified, exposures to subprime losses through the asset-backed commercial paper market, leading to a more general loss of confidence. The delay in discovering the location of the subprime-related losses reflected the complexity of some of the structures into which pools of subprime loans had been placed (particularly CDOs); the illiquidity of the underlying markets, which made it difficult to obtain a market price; and the reluctance of the rating agencies to downgrade these instruments. When the rating agencies eventually downgraded a large number of asset-backed securities, however, it became clear that many of them had been bought by off-balance-sheet bank subsidiaries (“conduits”) using short-term funds from the asset-backed commercial paper market.
Lenders, realizing that the underlying assets were not sound, pulled out of asset-backed commercial paper market, triggering wide-ranging liquidity problems. As the commercial paper market shrank, U.S. and European banks were forced to provide lines of credit to these conduits and accept in return the impaired collateral.
Outstanding U.S. Commercial Paper
Sources: Haver Analytics; U.S. Federal Reserve; and national authorities.
The resulting uncertainty about the quality of banks’ balance sheets led to a rapid increase in risk aversion, and investors’ “flight to quality” led to a fall in yields on (particularly short-term) government paper, while spreads on investment-grade and (in particular) high-yield corporate debt rose sharply and equity markets plummeted across the globe. The interbank markets on both sides of the Atlantic experienced serious disruptions, with 1–6-month money essentially unavailable and shorter-term funds only available at a sizeable premium. In addition, in Canada, some banks were able to avoid supporting conduits, resulting in a standstill in parts of the commercial paper market.
Central banks responded by providing liquidity at penalty rates. The U.S. Federal Reserve and, in particular, the European Central Bank used open market operations to inject substantial amounts of liquidity directly into markets. To further support market liquidity, the Fed also lowered its discount rate—at which it stands ready to lend directly to banks at a penalty spread while accepting a relatively wide range of collateral—eased terms of access, and allowed banks to increase temporarily loans to nonbank subsidiaries, above usually allowed limits.
However, liquidity in interbank markets remained tight. Despite ample provision of short-term funds, interbank lending at the 1–6-month term remained clogged. With concerns about counterparty risk lessening, banks appear to have been hoarding their cash in response to: high demand for loans, as borrowers activated contingent credit lines; uncertainty about cash needs, as commercial banks faced the prospect of honoring more off-balance-sheet commitments and investment banks of accommodating commitments for leveraged-buy-out-related loans; and, more speculatively, because banks wanted cash to buy distressed assets that will come into the market.
In response, on September 18, the Fed lowered the federal funds rate by 50 basis points to help offset the negative impact on the macroeconomy. With U.S. banks’ demand for cash remaining high, however, money market conditions remain difficult and it may take some time for interbank markets to return to full liquidity, while in Canada the standstill in the asset-backed commercial paper market has yet to be resolved. More generally, there appears to have been a global repricing of risk, implying that spreads on risky instruments are unlikely to return to levels seen in recent years, with negative consequences for global activity. On October 15, three major financial institutions, Citigroup, Bank of America, and JPMorgan Chase, agreed to set up a fund of as much as $80 billion to help revive the asset-backed commercial paper market, although it is still too early to see the effect of this step.
U.S. Short-Term Interest Rates
Sources: Haver Analytics; and the U.S. Federal Reserve.
Financial Conditions Map
Sources: Haver Analytics; Bloomberg, L.P.; CEIC; and IMF staff calculations.
Against this background, the U.S. dollar has continued to depreciate against the euro, the Canadian dollar, and a broad range of other currencies, including those of emerging market countries. While the mix has varied by country, exchange market pressures in emerging markets have generally been reflected in exchange rate appreciation, rapid accumulation of international reserves, and strong domestic credit growth.
Outlook for the United States and Canada
Growth in the United States is projected to slow to 1.9 percent in 2007 and 2008, significantly below potential. This weakness largely reflects a continuation of the current downturn in the housing market. With housing starts and house price inflation continuing to drop rapidly, rising inventories and foreclosures suggest that residential investment will continue to subtract from growth during 2008. Consumption growth also slows as personal wealth is adversely affected by falling nominal house prices, exacerbated by the short-term impact of recent financial market strains on lending and confidence. External demand, however, should provide some cushion to activity as the combination of slower domestic activity and robust foreign growth boosts net exports.
The Federal Reserve (Fed) cut rates in mid-September to “help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.” The federal funds rate had earlier been kept at a mildly restrictive 5¼ percent since mid-2006 despite slowing growth, allowing core inflation to decelerate from an uncomfortably high 2.5 percent early this year to 1.8 percent in September. The Fed initially reacted to financial market turmoil in August with substantial liquidity injections, waiting until the next scheduled meeting of the federal open markets committee on September 19 to cut the federal funds rate by 50 basis points. While financial conditions have improved recently, with equity markets hitting new highs in October, money market strains have continued, most notably in 1–6-month interbank markets. On October 31, 2007, the federal funds rate target was reduced by a further 25 basis points, to 4½ percent.
Equity Markets in the U.S., Europe, and Japan
Source: Bloomberg, L.P.
U.S. Financial Market Volatility
Source: Bloomberg, L.P.
Residential Investment and Housing Prices
Sources: Haver Analytics; national authorities; and IMF staff calculations.
In the baseline scenario, the drag on growth from the housing sector gradually lessens through 2008 while consumption is supported by solid labor market fundamentals. Overall, annualized GDP growth is projected to recover from 1½ percent in the fourth quarter of 2007 to just above 2½ percent a year later. Pressures on core inflation are expected to ease further, driven by a widening output gap and a slowing in the cost of shelter.
U.S. Real GDP
Sources: Haver Analytics; and IMF staff calculations.
Risks to this already modest U.S. growth outlook are clearly tilted to the downside for three main reasons. First, the housing downturn could be even deeper than currently projected, leading to weaker residential investment and larger knock-on effects on wealth and consumption. Second, the ongoing financial market strains could lead to a substantial and extended tightening in financing conditions, further dampening consumption and investment growth. Third, there is the risk that the recent slowing of productivity growth could be more permanent and structural in nature than expected, which, through expectations of lower future income, would also reduce consumption and investment spending.
At unchanged real exchange rates, the current account deficit is projected to decline further to 5¾ percent of GDP in 2007 and 5½ percent in 2008, despite continued high oil prices. This largely reflects the impact of the slowdown on the demand for imports, and the external deficit could improve further if downside risks to activity to materialize. Turning to financing, if foreign investors maintain their recent caution about purchasing U.S. assets then it is possible that the recent weakening in the value of the dollar will continue as funding costs rise.
Continuing the trend seen in recent years, fiscal developments have remained favorable, with the federal government deficit in FY 2007 improving by ¾ percentage point of GDP to 1¼ percent of GDP. The overperformance primarily reflects strong revenue buoyancy but also slower-than-expected spending execution. The deficit is expected to increase modestly in FY 2008 (which started in October) as revenue buoyancy tapers off and spending rebounds. The key fiscal challenge remains reforming unsustainable entitlement programs, preferably combined with a more stringent medium-term fiscal target, such as budget balance excluding the social security surplus.
In Canada, growth has remained buoyant, although some slowing is projected for 2008. Strong domestic demand and substantial terms of trade gains—on account of increasing commodity prices—have supported the economy, and the unemployment rate has declined to a 33-year low of 6.0 percent. Slower U.S. growth and financial market difficulties are likely to dampen activity moving forward, and annual growth is projected to slow to 2.5 percent in 2007 and 2.3 percent in 2008. Risks to the near-term growth outlook for Canada are also on the downside, largely reflecting possibly weaker U.S. prospects but also concerns about domestic financial conditions and currency appreciation.
The global liquidity squeeze has adversely affected Canada’s interbank market, notwithstanding conservative regulatory and business practices that minimized the initial impact of financial volatility on the balance sheets of major banks. About one-third of the asset-backed commercial paper market—equivalent to 2½ percent of GDP—was put into a standstill in August. If this standstill is not resolved quickly, there are concerns that money market liquidity conditions could tighten further. Against this backdrop, interest rates were left on hold in early September even though the economy was still operating above potential. Nevertheless, with domestic demand set to weaken, inflation is expected to moderate back to the midpoint of the Bank of Canada’s 1–3 percent target range, after a pickup in late 2006 and early 2007.
The commodity-related terms of trade gains have also strengthened the external current account surplus, which is projected at 1.8 percent of GDP in 2007 and 1.2 percent in 2008. At the same time, the Canadian dollar, which is widely considered to be a commodity currency, has risen to parity against its U.S. counterpart—its highest level in 30 years. In real effective terms, the Canadian dollar has now appreciated by some 45 percent from its low in early 2002. This real appreciation largely reflects higher commodity prices. But recent strength—with appreciation of 5 percentage points in the last three months alone—may well reflect momentum effects in an environment of generalized U.S. dollar weakness. While the appreciation has adversely affected manufacturing, the Canadian economy has adjusted smoothly to currency strength overall, with flexible labor markets supporting employment gains in services, construction, and mining that more than offset losses in manufacturing.
Canadian Commodity Prices and Real GDP
Source: Haver Analytics.