I. The Global Economy and Outlook for the United States and Canada

International Monetary Fund. Western Hemisphere Dept.
Published Date:
November 2006
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A. The Global Context

Global economic growth remains robust. First–quarter growth was especially strong in the United States, but has slowed since. The expansion has gathered momentum in the euro area, notwithstanding a slow start in Germany, and the Japanese economy continues to expand. China’s growth remains rapid, with output expanding at an annual rate of more than 10 percent in the first half of 2006. Emerging Asia and Europe are also growing rapidly.

Global Outlook

(Real GDP; annual % change)

Source: WEO.

Although monetary conditions tightened in the first half of the year, conditions for growth mostly remain favorable, and the global economy is projected to expand by about 5 percent in 2006 and 2007. Robust growth in the first half of the year and higher commodity prices led key central banks to tighten monetary conditions, which has generally kept inflation subdued. Financial markets, however, have shown a heightened sensitivity to incipient global inflationary pressures, as evidenced by turbulence in both mature and emerging markets during May and June. In response to sell-offs in the United States and other mature markets, equity markets in Argentina, Brazil, Colombia, Hungary, Mexico, Russia, and Turkey experienced sharp declines. But these followed considerable increases, and markets have since regained strength. Moreover, sovereign spreads remain near historical lows, and the May-June turbulence did not appear to reflect a fundamental reassessment of prospects for emerging markets.

Global Equities: Price-to-Earnings Ratios

(3- month moving average) 1/

Sources: Thomson Financ ial I/B/E/S; and IMF staff estimates.

1/ 12-month forward earnings; period average (January 1990 - September 2006) = 100.

B. The Outlook for the United States and Canada

The United States remains a major engine of global growth, although growth is now expected to slow somewhat below potential. Following extremely strong growth of 5¼ percent in the first quarter (annualized, quarter on quarter), the pace of expansion in the United States fell back to 2½ percent in the second quarter. On an annual basis, growth is expected to decelerate from about 3½ percent in 2006 to around 2½ percent in 2007, as a cooling of the housing market slows residential investment and consumption spending. Business investment is likely to remain solid, especially in light of the recent decline in oil prices, strong profits, and low long-term interest rates. The risks to this forecast are mainly to the downside, particularly if there is a faster-than-expected weakening of housing activity in the next months. The external deficit is forecast to remain close to current levels, although weaker-than-expected activity could lower imports. Price pressures are expected to be contained, reflecting sustained productivity growth and some weakness in oil prices.

Performance on the fiscal front has been better than expected and the U.S. administration’s goal of halving the deficit is ahead of schedule. Due to a surge in tax revenues and success in containing nondefense discretionary spending, the federal deficit fell to just under 2 percent of GDP in FY 2005. However, longer-run sustainability remains a key challenge. Addressing it will require entitlement reform combined with medium-term deficit reduction to achieve broad federal budget balance (excluding the Social Security surplus). With greater exchange rate flexibility and supporting reforms in partner countries, such deficit reduction would also help reduce global imbalances and mitigate the risk of their disorderly resolution.

U.S. Real GDP Growth and Contributions

(Annualized quarterly contributions to growth; percent)

Source: Haver Analytics.

Federal Government Expenditure

(% of GDP)

Source: IMF Country Report No. 06/279.

The Canadian economy continues to grow closely in line with capacity. The economy is projected to expand by about 3 percent in both 2006 and 2007—although outcomes will be closely linked with those in the United States. Economic growth has been boosted by high commodity prices, private consumption growth and, as in the United States, healthy corporate profits and business investment, which have offset the drag of a strong currency. Notwithstanding a relatively tight labor market, inflation is expected to remain well-anchored within the context of the inflation-targeting regime and fiscal surpluses, which have kept the debt/GDP ratio on a downward trajectory.

Industrial Countries

(Real GDP, % change from four quarters earlier)

Source: IMF staff estimates.

C. Global Challenges

While the most likely near-term scenario for the global economy continues to be robust growth, the balance of risks is increasingly slanted to the downside. In addition to risks related to the cooling of the U.S. economy—which would especially affect Latin America—the global economy confronts a number of challenges over the near and medium term with implications for the outlook. These include (i) high and volatile energy prices; (ii) tighter global liquidity, in part in response to rising inflationary pressures; and (iii) the risks stemming from global imbalances.

Real GDP Growth

(Annual % change)

Source: IMF staff estimates.

Although they have declined following their August 2006 peak, high and volatile oil prices remain an ongoing challenge. In addition to buoyant global economic activity, spikes in oil prices earlier this year were driven by geopolitical events and supply concerns. Though these fears have recently receded, spare capacity is still at low levels, and the risk of supply-side shocks remains. A major disruption in one of the large producers could result in renewed price hikes, exacerbating inflationary pressures while also cooling demand. This underscores the need to achieve a sustainable medium-term supply/demand balance by eliminating obstacles to upstream and downstream investment to boost capacity, strengthening conservation efforts, and gradually reducing price subsidies that contribute to high demand over the medium term.

World Crude Oil Demand, Production Capacity, and Spare Capacity

(millions of barrels per day)

Sources: British Petroleum Statistical Review; International Energy Agency; and IMF staff.

Financial market volatility earlier in the year highlighted the potential risks for emerging markets from an unexpected tightening in global liquidity conditions. So far, rising interest rates in the United States and elsewhere have not dampened growth in emerging markets, and further moderate hikes could be absorbed without much difficulty. Going forward, the challenge for major central banks will be to guard against inflationary pressures in a predictable manner that avoids excessive tightening.

Global imbalances remain a pressing policy challenge for the global economy. Over the past 10 years, the U.S. current account deficit has risen to unprecedented levels, matched by very large surpluses in Asia and—more recently—oil-producing countries. There is broad agreement that these imbalances are unsustainable over the medium term and that there is a risk that they could eventually lead to a disorderly adjustment, including a reduction in the demand for U.S. assets, abrupt movements in interest and exchange rates, rising protectionist sentiment, and a slowdown in global growth. The IMF is currently engaged in a multilateral consultation process, involving China, the euro area, Japan, Saudi Arabia, and the United States, to promote joint action toward reducing global imbalances while sustaining growth.

Equity Markets in the U.S., Europe, and Japan

(January 1, 2004 = 100)

Source: Bloomberg, L.P.

Current Account Balance

(In percent of World GDP)

Source: WEO.

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