Chapter II Toward Better Balanced Growth in Industrial Countries
Author: International Monetary Fund. Research Dept.
Language:
English
Keywords:
WEO; fuel exporter; debt ratio; real GNP; long-term debt; debtor country; federal budget; deutsche mark; dollar depreciation; price decline; pound sterling; Oil prices; Exchange rates; Inflation; Terms of trade; Budget planning and preparation; Europe; North America; Current account
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Abstract

The industrial countries appear now to have entered a period of sustained and better balanced growth. Until recently, the cyclical recovery that began late in 1982 had been characterized by sharp divergences in both policies and economic performance among the major countries. There are now several indications that policies and performance are beginning to converge. In particular, a more sustainable pattern of growth across countries seems to be emerging, while inflation rates continue to decline and inflation differentials are narrowing further. In addition, both the September 1985 exchange rate initiative by the Group of Five and the adoption of a balanced budget act in the United States in December 1985 indicate that the authorities in the largest countries intend to deal with several serious manifestations of imbalances, in particular the high value of the dollar and the large U.S. budget and current account deficits. Although many uncertainties persist, it does appear that some of the downside risks to the outlook for industrial countries have diminished in importance.

The industrial countries appear now to have entered a period of sustained and better balanced growth. Until recently, the cyclical recovery that began late in 1982 had been characterized by sharp divergences in both policies and economic performance among the major countries. There are now several indications that policies and performance are beginning to converge. In particular, a more sustainable pattern of growth across countries seems to be emerging, while inflation rates continue to decline and inflation differentials are narrowing further. In addition, both the September 1985 exchange rate initiative by the Group of Five and the adoption of a balanced budget act in the United States in December 1985 indicate that the authorities in the largest countries intend to deal with several serious manifestations of imbalances, in particular the high value of the dollar and the large U.S. budget and current account deficits. Although many uncertainties persist, it does appear that some of the downside risks to the outlook for industrial countries have diminished in importance.

The rate of growth in the industrial countries slowed to a moderate 2.8 percent in 1985, which was significantly below the 4.7 percent recorded in 1984. The slowdown was dominated by developments in the United States, where growth fell to 2.2 percent, compared with 6.5 percent in 1984. But the rate of expansion also moderated in Japan. In the industrial countries of Europe, growth averaged only 2.3 percent, which was not sufficient to prevent a further rise in unemployment. Price increases have continued to moderate, particularly in countries with above-average inflation rates. The rate of increase in the composite GNP deflator for industrial countries fell to 3.9 percent in 1985, the lowest inflation rate since 1967.

In 1986 and 1987, the main forces that are expected to influence the industrial economies comprise a tighter fiscal policy stance in North America, somewhat easier fiscal policy in Europe, and a tendency for monetary conditions to ease in most countries. In Japan, the fiscal stance is assumed to remain tight. The significant depreciation of the dollar since March 1985 will also affect the pattern of growth, and will help to reduce inflation further outside the United States. In addition, price performance and real income developments in the industrial countries are expected to be favorably influenced by the recent marked decline in oil prices and, hence, by a significant improvement in the terms of trade vis-à-vis the oil exporting countries. Together with revaluation effects in bond and stock markets, these influences are likely to have a beneficial impact on confidence of consumers and investors. Overall, growth in the industrial countries is projected to average some 3 percent in 1986, rising to 3¼ percent in 1987, with rates of expansion in most countries expected to cluster in the 2½–3½ percent range.

The projections are based on the assumptions that the price of internationally traded oil, which is estimated to have declined to $19 per barrel in the first quarter of 1986, will average $15 per barrel for the remainder of 1986 and in 1987, and that exchange rates will remain unchanged in real effective terms from their level in the first week of March 1986. These assumptions imply that nominal oil prices are assumed to decline by as much as 40 percent in 1986 in dollar terms; in real terms—when deflated by the projected increase in export prices of manufactures—oil prices are assumed to be approximately halved. For the effective exchange rate of the dollar, the estimated depreciation by early March 1986 was about 25 percent from the peak a year earlier. If the dollar were to remain at its early March level through 1986, the effective depreciation would amount to about 15 percent for 1986 on average. With rates of inflation projected to converge across the industrial countries—in part because of the lower value of the dollar—the real depreciation of the dollar would be of the same order of magnitude.

While the dollar depreciation primarily affects the pattern of growth and inflation across countries, the oil price decline is likely to have a substantial net beneficial impact on the industrial countries in general. Such benefits comprise a real income gain (of almost ¾ of 1 percent of GNP in 1986), lower consumer price inflation (between 1 and 1½ percent lower in 1986 and 1987 than would otherwise have been predicted), and favorable influences on confidence. With lower inflation, monetary conditions would be likely to ease, and lower energy prices would also have beneficial supply-side effects, in particular through their impact on profitability and real labor costs. Overall, these effects are expected to more than offset the impact of reduced exports to the oil exporting developing countries, and the negative implications of an oil price decline for the industrial countries’ domestic energy sectors and, perhaps, for some parts of their financial sectors.

Apart from the uncertainty about the extent and timing of budget deficit reductions in the United States, and about the debt situation in the developing countries (analyzed in Chapter V), the principal remaining concerns for the industrial countries are the continuation of large external payments imbalances in the United States, Japan, and the Federal Republic of Germany, and the persistence of high unemployment rates in Europe and Canada. The significant depreciation of the dollar over the past year and the assumed adjustment of fiscal policy in the United States will help prevent larger current account imbalances among the industrial countries but are unlikely to reduce these imbalances much in the short run. Uncertainty will therefore persist both in the area of exchange rates and with respect to protectionist sentiment which continues to constitute an important downside risk. In Europe, growth is not expected to accelerate enough to make major inroads into unemployment, which, it is increasingly recognized, reflects structural factors to a considerable extent. While the possibility of further downward pressure on oil prices cannot be ruled out, it is important to recognize that in the event that some form of restraint on oil production is re-established, a partial reversal of the recent decline in oil prices could take place. (For a detailed discussion of oil market conditions, see Supplementary Note 4.)

This chapter reviews the outlook for the industrial countries in more detail. The first section outlines the setting of economic policy, dealing both with policy objectives and with the difficulties connected with the implementation of policies. The following section discusses the macroeconomic implications of the recent decline in oil prices. This is followed by a review of demand and output developments in 1985, together with a presentation of the staff’s projections for 1986 and 1987. The next sections analyze developments in labor markets and in inflation. A main topic dealt with in these sections is the impact of the projected improvement in the industrial countries’ terms of trade on employment and inflation. The review of domestic developments is followed by an analysis of developments in exchange rates and balances of payments. The chapter concludes with a discussion of some of the principal uncertainties in the projections.

The Policy Setting

Following the Group of Five initiative in September 1985 and the adoption of a balanced budget act in the United States in December, both the pattern and the mix of economic policies in the industrial countries are expected to change significantly in 1986 and 1987 compared with the past four years. The policy assumptions underlying the projections in this World Economic Outlook, which are based on existing or announced policies, suggest that fiscal policy in the major countries as a group will tighten somewhat over the forecast period. The assumptions also point to a tendency for fiscal policy stances across countries to converge. This convergence would be in sharp contrast to the divergent pattern of policies that has prevailed since the beginning of the decade and should contribute to reducing imbalances in foreign trade and in financial markets. As illustrated by the concerted reduction of official discount rates in the three largest countries early in March 1986, the prospect of tighter and more convergent fiscal policies has already contributed to lower interest rates and has facilitated the efforts of the authorities of major countries to bring about a more sustainable pattern of exchange rates. At the same time, it is apparent that the risk of a substantial renewed rise in interest rates has diminished.

Since the beginning of the 1980s, policy objectives in the industrial countries have been formulated in a medium-term framework, with particular emphasis on the need for significant reductions in rates of inflation, in the size of the public sector, and in government budget deficits. These objectives have been viewed as necessary conditions for achieving a sustainable improvement in profitability, investment, and growth over the medium to longer run. At the same time, many governments have striven to improve the functioning of markets, particularly those for labor and financial services. In some countries, privatization of publicly controlled enterprises has also been pursued in an effort to enhance competition and efficiency in markets for both goods and non-financial services.

The strategy adopted has had a number of notable successes. Substantial progress has been achieved both in the area of inflation control and, albeit not in all countries, in budget positions. However, it has to be recognized that there have been several setbacks in implementing the strategy. The rising budget deficit in the United States, in particular, has been a cause of concern, both because of its impact on exchange rates and because of the upward pressure on real interest rates to which it contributes. If, indeed, the United States is now on the path of medium-term deficit reduction, a major element of uncertainty will have been, if not eliminated, at least reduced in importance.

Fiscal Policy

According to fiscal impulse estimates for the broader definition of government (general government), the thrust of fiscal policy in the major industrial countries, taken together, is expected to become somewhat more restrictive over the forecast period than it has been during the last four years (Chart 3). This mainly reflects an expected removal of stimulus in Canada and, particularly in 1987, in the United States. The budgetary policy assumptions adopted suggest that policies will continue to differ across countries, in part reflecting the need for budget consolidation in countries with large remaining budget deficits. Nevertheless, compared with the experience over the past four years, the fiscal outlook for 1986–87 exhibits a clear tendency toward policy convergence. It is, however, more than usually difficult to make projections of fiscal developments, given the uncertainties about the constitutionality of recent budgetary initiatives in the United States as well as about the manner in which such initiatives would be implemented. (For a detailed discussion of fiscal policy developments in industrial countries, see Supplementary Note 1.)

Chart 3.
Chart 3.

Major Industrial Countries: Fiscal Impulses, 1982–85 and 1986–871

(In percent of GDP/GNP at annual rates)

1 General government, that is. centra] and local authorities plus social security. Data are on a national accounts basis. A positive fiscal impulse indicates injection of stimulus; a negative impulse indicates withdrawal of stimulus. For the definition of the fiscal impulse, see Supplementary Note 1.2 Excluding asset sales.

There have been several important developments in the budgetary situation in the United States over the past six months. The compromise budget guidelines established in the Congressional Resolution in August 1985 aimed at reducing the federal budget deficit to $175 billion in fiscal year 1986. This compares with a deficit of $210 billion in fiscal year 1985 and a projected deficit of $230 billion in fiscal year 1986 in the absence of policy changes. Notwithstanding some uncertainty regarding the extent to which these budgetary savings would be achieved (in part because of new appropriations, such as the Farm Bill), the subsequent adoption of the Gramm-Rudman-Hollings balanced budget act in December indicates that a fundamental shift in policy priorities may be taking place. The Administration’s budget for fiscal year 1987, released early in February, proposed budgetary changes designed to meet the deficit target stipulated by the balanced budget act which requires a deficit of no more than $144 billion (3.2 percent of GNP) in fiscal year 1987 (and a balanced budget in fiscal year 1991).

In light of the uncertainty surrounding the legal status of the Gramm-Rudman-Hollings legislation, the staff has adopted the assumption that the deficit reduction measures actually implemented will not be sufficient to meet the targets fully, in part because of a somewhat lower projection for growth than assumed by the U.S. Administration. According to the staff’s projections, the federal deficit would thus decline to around 3½ percent of GNP in fiscal year 1987 (and would remain at about 2½ percent of GNP in fiscal year 1991) compared with a deficit equivalent to 5.4 percent of GNP in fiscal year 1985. Even on this assumption, however, the fiscal stance in the United States would undergo a major change from the sizable injection of stimulus over the four years 1982–85. (The medium-term implications of a more rapid implementation of the balanced budget act are analyzed in Chapter IV, “Policy Interactions in Industrial Countries.”)

In Japan, the fiscal balance of the general government sector has strengthened substantially from a peak deficit of 5½ percent of GNP in 1978 to a projected deficit of only 1½ percent of GNP in 1986. The central government’s deficit has fallen by much less, and remains close to 5 percent of GNP. Because of the size of the deficit, the substantial increase in central government debt over the past ten years, and a prospective large increase in social security payments, the Japanese authorities continue to emphasize budgetary consolidation at the central government level as a major policy objective. It is their intention to cease issuing deficit-financing bonds—bonds which finance current expenditures—by fiscal year 1990. Notwithstanding this medium-term objective, concern over the outlook for growth led to the adoption of measures to stimulate domestic activity in October 1985 and in the proposed budget for 1986/87. These measures focus on increasing public works expenditure by local authorities, whose budget situation has improved considerably over recent years, and by public enterprises financed by the Government’s lending operations. Even with increased local government spending, however, a withdrawal of stimulus of about ½ of 1 percent of GNP at the general government level is likely to occur in 1986. Continuation of this policy stance would imply a further slight withdrawal of stimulus in 1987.

In the Federal Republic of Germany, the stance of fiscal policy is expected to ease somewhat this year as a result of tax cuts amounting to DM 11 billion (0.6 percent of GNP). Nevertheless, it remains an overriding policy objective to reduce the size of the public sector in relation to GNP, and the 1986 budget is characterized by continued restraint on the expenditure side. Because of this restraint, and reflecting also the expected pickup in growth, the general government budget deficit is forecast to decline further, both in 1986 and in 1987. In the latter year, it is projected, on present policies, to be only 0.6 percent of GNP (compared with 1.1 percent in 1985 and 3.7 percent as recently as in 1981). A second stage of tax cuts (amounting to DM 8.5 billion) is scheduled to take effect in 1988.

Fiscal policy in the United Kingdom has been somewhat more expansionary in recent years than intended under the medium-term financial strategy, because of greater difficulties in controlling the growth of public expenditure than had been foreseen. In the light of the recent oil price developments and their adverse impact on North Sea oil revenue, a major improvement in the fiscal position appears unlikely in the period immediately ahead. According to staff projections, which are based on the 1986/87 budget that was made public in March 1986, the public sector borrowing requirement will remain broadly unchanged in 1986 and 1987 from its 1985 level. Substantial increases in sales of public sector assets, together with buoyant non-oil revenues, are expected to offset to a significant degree a projected decline in oil revenues. However, the fiscal impulse measure for the general government sector, which refers to national accounts estimates exclusive of asset sales suggests that the fiscal stance will move marginally in the direction of expansion (by ¼ of 1 percent of GDP) in 1986 and be approximately neutral in 1987.1

The budgetary posture in France is expected to remain cautious. Continued curbs on the growth of public expenditure are expected to permit an announced reduction of the tax burden to be financed without any significant increase in the budget deficit, which is projected to remain in the vicinity of 3 percent of GNP at the central government level. Budgetary objectives in Italy are for a small reduction in the central government deficit, which at about 16 percent of GNP in 1985 continues to be clearly the largest among the major industrial countries. In Canada, the budget deficit as a proportion of GNP was little changed in 1985 from a year earlier, notwithstanding a relatively rapid rate of economic growth and the implementation of a number of deficit reduction measures. Staff projections for 1986 and 1987, which are based on the federal budget announced in February of this year, point to a substantial improvement in the budgetary situation, both as a result of tax increases and slower planned growth in public expenditures. The reversal in the budgetary situation is estimated to lead to a large withdrawal of fiscal stimulus at the general government level in 1986 (equivalent to 1¼ percent of GNP), which is in sharp contrast to the injection of stimulus in the 1983–85 period.

Recent budgetary announcements in the smaller industrial countries continue to emphasize the need for deficit reduction. Although the implementation of deficit reductions, as in the major countries, has proven harder to achieve than was envisaged, the impact of budgetary changes in the smaller countries over the forecast period is likely to involve a continued slight withdrawal of stimulus. Nevertheless, with the exception of Denmark and Sweden, budget deficits in the smaller countries are expected to remain substantially higher than they were at the beginning of the decade. Lower oil prices are likely to lead to a sharp reduction of the budget surplus in Norway. With natural gas prices responding with a lag, the budget deficit in the Netherlands is expected to widen significantly in 1987.

Monetary Policy

Since the beginning of the 1980s, the principal objective of monetary policy in the major industrial countries has been to reduce inflation and inflationary expectations. For most countries, this objective has been achieved by setting progressively lower target growth rates for monetary aggregates. This non-accommodative approach to monetary policy has succeeded in breaking the escalating trend in monetary growth of the 1970s and has established the conditions necessary for a sustained deceleration in inflation (Chart 4). While the pursuit of monetary targets continues to be an important intermediate objective, the implementation of monetary policy has increasingly been adapted to take account of prevailing economic circumstances and of shifts in the underlying velocity of targeted monetary aggregates. As monetary authorities have acquired greater credibility in their commitment to control inflation, they have become more willing to allow shifts in velocity to be reflected in the monetary aggregates rather than in monetary conditions. Nevertheless, the benefits of accommodating such shifts in velocity have continued to be weighed against the risk of unintended easing of monetary conditions which would endanger inflation control.

Chart 4.
Chart 4.

Major Industrial Countries: Money Supply, Nominal GNP, and GNP Deflator, 1970–87

(Annuai changes, in percent)

In 1985, the rate of growth of narrow money in the seven major industrial countries accelerated to 10.1 percent on an end-of-year basis compared with 6.9 percent during 1984, while the growth rate of broad money rose to 8.9 percent, 1 percentage point above the previous year’s rise. However, in several countries the behavior of the velocity of key monetary aggregates was distorted, as it had been in some earlier years, by the effects of financial innovation and by a further reduction in underlying inflation rates. In the United States, the velocity of M1 declined sharply in the first half of the year, although the decline did not extend to the broader monetary aggregates. In part reflecting this development, the authorities de-emphasized the role of M 1 as a guide to policy, while giving somewhat greater weight to the broader aggregates and to other economic and financial indicators. In the United Kingdom, the performance of the two targeted aggregates diverged significantly during the year: M0, the wide monetary base, trended along the bottom of its target range while the growth of sterling M3 significantly exceeded the upper end of its range. In view of the recent liberalization of financial markets and the high level of real interest rates, the authorities decided to accept the faster growth of sterling M3 and to assign increased weight to MO and to the exchange rate, as well as to other financial indicators in the conduct of monetary policy. In the other major industrial countries that announce target (or forecast) growth ranges for monetary aggregates—Japan, France, and the Federal Republic of Germany—the outturns were more consistent with the announced targets (see Chart 32 in Supplementary Note 2).

Short-term interest rates fell significantly in several of the major industrial countries during 1985 (Chart 5). Short-term interest rates in the United States fell by approximately 3½ percentage points from their 1984 peak as the monetary aggregate M1 was permitted to grow more rapidly than targeted in the face of a deceleration of output growth and a continued low rate of inflation. Interest rates also fell quite sharply in France, the Federal Republic of Germany, and Italy. In the United Kingdom, however, the authorities allowed base lending rates to rise by 4½ percentage points early in 1985, on concern about the quickening of the rate of depreciation of sterling and the associated perception that monetary policy had become too loose. Base rates then declined gradually during the year as sterling strengthened on foreign exchange markets. In late 1985 and early 1986, however, sterling again came under pressure, triggering a renewed rise of 1 percentage point in base lending rates in January 1986. In Japan, short-term interest rates were stable at their 1984 level for the first nine months of the year, but rose 1¾ percentage points from September to December, reflecting greater emphasis on exchange market considerations in the conduct of monetary policy.

Chart 5.
Chart 5.

Five Major Industrial Countries: Interest Rates, 1980–86

(In percent)

1 Monthly averages of daily rates on money market instruments of about 90 days’ maturity.2 Monthly averages of daily or weekly yields on government bonds, with maturities ranging from 7 years for Japan to 20 years for the United States and the United Kingdom.3 The United States, Japan, France, the Federal Republic of Germany, and the United Kingdom.4 Interest rates deflated by a weighted average of the increase in the private final domestic demand deflator in the current and the following two quarters; for the most recent periods, Fund staff projections of the deflator are used.

The first three months of 1986 have witnessed further significant reductions in short-term interest rates in most of the major countries in response to significant changes in the pattern of exchange rates and to the continued improvement in the outlook for inflation stemming from the sharp drop in oil prices. These developments have permitted a reversal of the firming of interest rates in Japan and the United Kingdom that occurred in late 1985 and early 1986. In early March, the declining trend in interest rates led to a concerted cut in official discount rates by ½ of 1 percentage point in the three largest industrial countries.

Long-term interest rates fell by slightly more than short-term rates in the major industrial countries during 1985 and early 1986, implying that the yield curve tended to flatten in several countries. In the United States, as financial markets reacted to the growing likelihood (and eventual passage) of the balanced budget act, long-term interest rates fell significantly toward the end of the year, thereby narrowing the spread with respect to short-term rates. Long-term interest rates also fell significantly in France, the Federal Republic of Germany, Italy, and Canada during 1985. In Japan, long-term interest rates rose early in 1985 and then declined gradually, falling below short-term rates. In the United Kingdom, the yield curve became inverted in 1985 as long-term interest rates increased by significantly less than short-term rates at the beginning of the year and finished the year below the closing levels of 1984.

Adjusted for changes in the rate of inflation, yield differentials across countries narrowed somewhat last year. In particular, real short-term interest rates fell significantly in North America, whereas they rose somewhat on average in the other major industrial countries.2 Long-term interest rates also declined significantly in real terms in all the major countries except the United Kingdom, with the most pronounced reduction being in North America. Nevertheless, despite the significant reductions in real interest rates over the past year, both short-term and long-term real interest rates remain high by historical standards.

The target growth ranges for monetary aggregates announced thus far for 1986 reflect the continuing objective of controlling inflation. In the United States, the targets announced in February 1986 call for a continuation of the 3–8 percent growth range for M 1 established last July for the remainder of 1985. A 6–9 percent range has been maintained for M2, and a similar range has been established for M3. In France, the authorities have redefined the monetary aggregates as a result of financial innovations and have set an ambitious target growth range for M3 of 3–5 percent in 1986. The Federal Republic of Germany, which has had one of the best inflation performances among the industrial countries, has raised slightly the target range for the growth of central bank money from 3–5 percent in 1985 to 3½-5½ percent in 1986. This reflects a small increase in the potential rate of output growth (as estimated by the authorities) in 1986 compared with 1985. In the United Kingdom, the authorities have set a 1986–87 target range of 2–6 percent for MO (the wide monetary base). A somewhat higher range of 11–15 percent has been set for sterling M3 to allow for an expected further shift in the allocation of portfolios toward interest-bearing deposits. Overall, in view of the projected developments in real GNP growth and inflation, together with the move toward a more restrictive stance of fiscal policies in the major industrial countries as a group, the announced targets seem to be consistent with some further easing of financial market conditions in most of the major countries during 1986. (Monetary policy developments in the major industrial countries are discussed in more detail in Supplementary Note 2.)

Impact of Lower Oil Prices

The recent decline in oil prices has significantly improved the short-term prospects for domestic demand growth in the fuel importing industrial countries. At the same time, inflation rates are likely to moderate further, which by itself should contribute to prolong the current recovery.

While large fluctuations in oil prices have been observed in the past—in 1973–74 and in 1979–80—the effects of a sharp decline in oil prices are unlikely to be completely symmetrical to those of sharp price increases. In the first place, a key factor behind the recession following each of the two rounds of price increases was a temporary rise in the world’s saving ratio, reflecting differences in the short-run spending propensities as between oil exporting and oil importing countries. In the current situation, where many oil exporting countries are already experiencing deficits on their current accounts and severe debt-servicing problems, the decline in oil prices is unlikely to result in a commensurate decline in the world saving ratio. Second, the anti-inflationary tightening of financial policies that followed the oil price increases of the late 1970s also aggravated the subsequent recession. At the current juncture, however, with policies set in a medium-term framework, a corresponding discretionary easing of policies is unlikely. Overall, therefore, it seems unlikely that the effects of the present declines in oil prices will be as favorable as those of past oil price increases were unfavorable. Nevertheless, the favorable effects for fuel importing countries should be considerably greater than those stemming from the global redistribution of real incomes. On the assumption that monetary targets are not reduced to reflect the decline in inflation, monetary conditions can be expected to ease somewhat. In addition, the reduction in rates of inflation can be expected to result in positive wealth and real balance effects. Both factors should generate a significant net positive impact on output in the oil importing countries.

The direct effect of the assumed decline in oil prices from $26.70 per barrel in 1985 to some $16 per barrel in 1986 (representing an estimated price of $19 in the first quarter and an assumption of $15 thereafter) will be to lower the net oil import bill of the industrial countries by some $60 billion on an annual basis, which corresponds to almost ¾ of 1 percent of the industrial countries’ GNP. This real income gain accounts for most of the projected improvement in the industrial countries’ terms of trade in 1986. (The continued erosion of real non-oil commodity prices accounts for approximately one fourth of the total terms of trade gain.) For individual countries, the projected terms of trade movements are influenced by changes in the exchange rate as well. As a result, the projected improvement in the United States’ terms of trade is somewhat smaller than in the case of Japan and the oil importing countries in Europe (Table 2).

Table 2.

Industrial Countries: Terms of Trade Changes and Real National Income, 1980–87

(In percent)

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Terms of trade gains in industrial countries will act to raise both profits and the real disposable incomes of consumers more than otherwise would be the case. Exactly how these gains will be distributed between consumers and enterprises is difficult to estimate, but the total impact on real national income is expected to amount to approximately 2½ percent in the case of the oil importing countries in Europe and in Japan. In view of these terms of trade gains, it cannot be excluded that demand and activity in Japan and Europe might in fact turn out somewhat stronger than projected at this juncture. This would partly depend on the impact of the oil price decline on confidence. There are clearly risks to a major decline in oil prices—because of the repercussions on the financial institutions heavily exposed vis-à-vis the oil producing countries, or vis-à-vis the industrial countries’ domestic energy sectors. Nevertheless, to judge from the buoyancy of stock markets late in 1985 and early in 1986, the confidence of financial investors has improved dramatically along with the decline in oil prices.

A substantial proportion of the terms-of-trade-induced increase in real incomes stemming from lower oil prices is likely to be offset by reduced exports to the oil exporting countries, even though the adjustment may not be completed until after a few years. The projections assume that import volumes in the fuel exporting developing countries will decline by 15 percent in 1986, and by an additional 8 percent in 1987. This would still leave these countries’ current account deficit at $49 billion in 1986, and at some $36 billion in 1987, compared with a deficit of $7 billion in 1985. (The impact on the fuel exporting countries is discussed in more detail in Chapter III.)

The reduction of oil import prices is expected to feed through gradually to consumers, partly through lower prices of other sources of energy. Such sympathetic price responses may not be felt until after a period. (Natural gas prices, for example, are often linked to oil prices with a lag.) Of course, to the extent energy taxes are increased to prevent a reversal of conservation efforts, such effects may not materialize. However, at this stage, most oil importing countries seem prepared to pass on the bulk of the oil price reduction to consumers and enterprises. In addition to the impact on final energy prices, there are likely to be significant effects on inflation in general, including lower nominal wage increases. Indeed, these secondary effects on inflation may turn out to be as important as the direct impact of lower oil prices. Overall, consumer price increases in industrial countries are expected to be reduced by 1–1½ percent in 1986 and 1987 as a result of the decline in oil prices.

Assuming an unchanged growth path for monetary aggregates, the reduction in rates of inflation is expected to have a favorable impact on monetary conditions. As such, the recent decline in interest rates may be interpreted as part of the beneficial effects of lower oil prices. The stance of fiscal policy may also be affected to some extent. In some countries, budgetary expenditures are established in nominal terms, so that as inflation decelerates, the level of real expenditure that is implied by nominal appropriations rises. Offsetting this factor, however, there may be a need for some countries to use the opportunity afforded by lower oil prices to accelerate the process of fiscal consolidation. Governments in oil producing industrial countries may also decide to offset part of the revenue loss from the oil sector by tightening fiscal policy.

Overall, tentative staff estimates suggest that the level of real GNP in the industrial countries at the end of the forecast period could be between and 1 percent higher as a result of the reduction in oil prices. Most of the impact would be attributable to the secondary effects of disinflation and improved business and consumer confidence. Assuming that the price decline is sustained, over the medium-to-longer run there would also be a number of favorable supply-side effects, including in particular lower real labor costs and higher labor intensity of output.

Output and Demand

The short-term prospects for the industrial countries suggest that economic expansion is likely to continue in 1986 and 1987 at a slightly faster pace than in 1985, when real GNP rose by 2.8 percent in the industrial countries as a whole. This kind of growth performance would be significantly below the rate of 4.7 percent achieved in 1984, but, given the duration of this recovery, would compare relatively well with the average performance over the two most recent international business cycles. As discussed below, even though the previous upswings were generally more vigorous during the initial two to three years of recovery, they have not typically been as long lived as the current expansion is expected to be.

The projected economic performance of the industrial countries, taken together, is much the same on a year-over-year basis as that presented in the World Economic Outlook, October 1985. However, for most countries, growth during 1986 (from the fourth quarter of 1985 to the fourth quarter of 1986) is expected to be significantly more rapid than was expected last October, mainly as a result of the decline in oil prices. In the case of the United States, growth is expected to pick up significantly despite the weaker-than-expected performance in late 1985. The depreciation of the dollar should improve the real foreign balance, and lower energy prices and interest rates will help to support domestic demand. These positive factors should offset the impact of lower growth in public spending as a result of budget cuts. The outlook for Japan has also been affected by exchange rate movements, with the yen having appreciated significantly vis-à-vis both the dollar and some European currencies. In addition, Japan’s projected exports to oil exporting developing countries have been revised downward substantially. The contribution of the foreign balance to the growth of output is therefore expected to turn negative in 1986. Even though domestic demand will be stimulated by the substantial improvement in the terms of trade, projected real GNP growth in Japan is now put at only 3 percent in 1986. The projected rate of growth of the European countries for 1986 has been revised upward slightly, reflecting the net effects of a negative contribution from the foreign sector—for much the same reasons as in the case of Japan—and stronger domestic demand growth reflecting both the expected improvement in Europe’s terms of trade and, in some countries, an improvement in business and consumer confidence. Overall, real GNP in the industrial countries is expected to grow by 3 percent in 1986, about the same as projected in the October World Economic Outlook. More tentatively, a slightly higher growth rate of 3¼ percent is expected for 1987.

As already mentioned, this recovery compares relatively favorably with previous expansion periods in terms of longevity. On average, postwar recoveries have tended to show serious strains by the third or fourth year. The projections suggest that the current recovery will continue through its fourth and fifth years, with growth in each of these years at 3–3¼ percent. While the current expansion so far is not as long as the recovery that began early in 1975, and which to date has been the longest postwar recovery, it is already longer than most earlier expansions and in particular than the recovery that began in 1971 (Chart 6). Growth in the 1971 recovery faltered after about three years, before giving way to the 1973–74 recession, which was partly attributable to the first oil price increase, but also reflected a tightening of financial policies in response to a sharp acceleration of inflation.

Chart 6.
Chart 6.

Major Industrial Countries: Recovery of Real GNP from the 1970–71, 1974–75, and 1980–82 Recessions

(Indices: fourth quarter 1971, first quarter 1975, and fourth quarter 1982= 100) 1

1 Data for the 1971–75 recovery exclude Italy.

The current upswing differs from the two previous expansion periods in three principal respects. First, the distribution of growth across countries has been more uneven on this occasion. In particular, growth in Europe has been significantly slower during this recovery, while growth in the United States has, on average, been comparable to previous recoveries. Second, the current recovery has so far taken place in a less favorable external environment than earlier recoveries—measured by trade volume developments—with a downward shift in the rest of the world’s demand for industrial countries’ exports. Finally, the current recovery has been associated with a marked deceleration of rates of inflation, whereas the two previous recoveries were characterized by high or accelerating inflation.

Differences among countries in the growth of output have largely reflected even more pronounced differences in rates of growth of domestic demand (Chart 6a). While domestic demand has grown at least as rapidly in the United States as in earlier upswings, demand has been much weaker this time in Europe and in Japan. If the projections are realized, this pattern will continue during the fourth and fifth years of the current recovery, but with some acceleration likely in the rate of growth of domestic demand in both Europe and Japan.

Chart 6a.
Chart 6a.

Major Industrial Countries: Recovery of Real Total Domestic Demand from the 1970–71, 1974–75, and 1980–82 Recessions

(Indices: fourth quarter 1971, first quarter 1975, and fourth quarter 1982= 100) 1

After growing rapidly in the first two years of this recovery, the U.S. economy slowed abruptly to a more moderate rate over the past year. There were two principal reasons for the marked slowdown in output growth, from 6.5 percent in 1984 to only 2.2 percent in 1985. In the first place, inventory accumulation fell sharply, reflecting a combination of fairly normal cyclical adjustments and prospects of declining commodity prices, which made it advantageous to run down inventories. Second, the trade deficit continued to widen, which meant that a declining share of the growth in demand was being met by domestic producers. In contrast to the weak performance of inventories and net exports, final domestic demand continued to grow at a relatively strong pace, reflecting a significant decline in the household saving ratio and strong growth of defense spending that caused total public expenditure on goods and services to rise by 6 percent in real terms. Business investment also continued to expand, albeit at a slower pace than in 1984.

Because of the decline in inventory investment, total domestic demand in the United States was particularly weak in the first half of 1985 (Table 3). A rebound in final domestic demand in the second half—attributable mainly to defense spending and residential construction—was more than offset by a further sharp deterioration in real net exports. As a result, real GNP growth decelerated to 2.0 percent (annual rate) during the second half of 1985, having grown at a rate of 2.6 percent during the first half.

Table 3.

Stages in U.S. Recovery, 1982–87

(Percent change during period; in real terms at annual rates)

article image

Changes expressed as percentages of GNP at the beginning of the period.

While some of the reasons that led to the pickup in U.S. domestic demand in the second half of 1985 are not expected to persist, other factors are expected to result in a significant strengthening of activity in 1986–87, The personal saving ratio is unlikely to fall much further from the extremely low level it reached toward the end of 1985; the growth of public expenditure will probably slow significantly; and business surveys suggest that non-residential investment will be less buoyant than over the past two years despite the decline in interest rates. Against this, however, lower oil prices should work to increase real household income, and the effects of the depreciation of the dollar should begin to be felt on the real foreign balance—at least to the extent of halting the earlier deterioration. Following the low level of inventory formation in 1985, this component is also expected to contribute to growth over the forecast period. On balance, real GNP is thus projected to grow at an annual rate of 3¾ percent during 1986 and by 3½ percent during 1987.

Real GNP in Japan rose by 4.6 percent in 1985. A decline in exports in the second half of the year was largely offset by stronger growth of domestic demand, particularly business fixed investment. In view of the recent appreciation of the yen and the significantly weaker prospects for Japanese exports, the outlook for growth has become less favorable. Whereas real net exports had provided for significant positive contributions to growth in 1984 and the first half of 1985, the real foreign balance is projected to deteriorate by more than 1 percent of GNP in 1986. Despite the substantial improvement in the terms of trade, domestic demand growth is not expected to accelerate enough to prevent a reduction in GNP growth to 3 percent in 1986. On the assumption of no further change in the external value of the yen, growth is tentatively projected to increase to 3¼ percent in 1987.

The slowdown of growth in the United States had little impact on the Canadian economy, which remained quite buoyant in 1985. Real GNP rose by 4.5 percent and total domestic demand by 5.4 percent, with both private investment (particularly residential construction) and consumption sustaining the recovery. Mainly because of the faster growth in domestic demand in Canada than in the United States, the real foreign balance had a small negative effect on activity, following a large positive contribution in 1984. The growth of output in Canada is expected to slow to 3¼ percent in 1986 and in 1987, reflecting a substantial withdrawal of fiscal stimulus as well as the lagged influences of the moderation of growth in the United States.

The rate of growth in the industrial countries in Europe in 1985 was similar to that in the previous year—2.3 percent. In terms of domestic demand, the situation improved somewhat, but the pace of the recovery clearly has remained unsatisfactory in view of the margin of slack in European labor markets. The year-over-year growth rate masks a rather uneven performance during the year. Growth was extremely weak in several countries in the first half of 1985, mainly reflecting an unusually harsh winter. In contrast, during the second half of 1985 there was a marked rebound in demand and activity. In 1986 and 1987, domestic demand in Europe is expected to strengthen markedly, reflecting substantial terms of trade gains as well as easier monetary conditions and a less restrictive fiscal stance. These forces are expected to more than offset the effects of a deterioration in Europe’s net exports, attributable mainly to declining imports by the oil exporting countries, and to weaker competitiveness vis-à-vis North American suppliers.

The recent improvement in performance in the Federal Republic of Germany is particularly encouraging. Even though the rebound in the second half of 1985 was not sufficient to prevent a deceleration in growth, from 3 percent in 1984 to 2.4 percent in 1985 as a whole, the strengthening of demand nevertheless should help to sustain a significantly higher rate of growth in 1986, when real GNP is projected to expand by 3¾ percent. With a small negative contribution expected this year from the foreign balance—in 1985 net exports contributed almost 1 percentage point to growth—domestic demand will become a more important source of expansion. The main factors behind the expected improvement in economic performance are a significant terms of trade gain (8 percent) and a cut in direct taxes, both of which will contribute to the growth of real disposable incomes. In addition, there are a number of indications that confidence is improving, which should help to sustain the growth of both consumption and investment. Growth is projected to moderate in 1987 (to about 2¾ percent), but would nevertheless remain higher than in the rest of Europe.

The French economy experienced sluggish growth again in 1985 (1.1 percent) as the contribution to demand of real net exports turned negative. Prospects for 1986 and 1987, however, suggest that the French economy is now also entering a recovery phase. Lower inflation, a significant terms of trade improvement, easier financial conditions, and an improvement in confidence all point to an acceleration of domestic demand growth, to perhaps 3 percent in both 1986 and 1987. Real GDP is estimated to rise somewhat less, reflecting a slight further deterioration in real net exports.

The United Kingdom had a relatively strong rate of growth of aggregate output (3.3 percent) in 1985, the country’s fourth year of recovery. However, because of the influence of the coal miners’ strike, which came to an end early in 1985, the recorded growth rate was somewhat higher than the underlying trend. The introduction of less generous depreciation allowances for business investment—which caused investment expenditures to be brought forward into 1985—also seems to have stimulated growth temporarily. As these influences subside, and on the assumption of continued application of restrained monetary policy, the growth of activity is expected to decelerate somewhat over the forecast period, to 2¾ percent in 1986 and to 2 percent in 1987.

The Italian economy is estimated to have grown by only 2.2 percent in 1985, which was slightly less than in 1984 (2.6 percent), mainly because of slower growth of public consumption and a decline in stockbuilding. Growth is expected to remain relatively subdued—at about 2¼ percent—in 1986 and 1987, with the impact of the improvement in the terms of trade being offset by a projected deterioration in real net exports.

In the smaller industrial countries, faster growth of final domestic demand in 1985 was more than offset by a reduction in the contributions to growth from stockbuilding and the foreign balance. These latter factors had been a major source of growth in 1984 but were more nearly neutral in 1985. Real GNP in the smaller countries increased by 2.8 percent in 1985—slightly below the growth rate of the previous year—with individual country outturns ranging from 1 percent in Ireland to 4¾ percent in Australia. In 1986 and 1987, growth in the smaller industrial countries is projected to remain at about 2¾ percent, on average, with domestic demand increasing at a slightly higher rate. Australia is projected to continue to grow faster than the other smaller countries. New Zealand, Belgium, and Sweden are expected to grow by somewhat less than the other countries, reflecting the continuation of efforts to reduce budget deficits.

Labor Market Conditions

Although unemployment rates remain at or near record high levels in many industrial countries, the outlook for employment creation is somewhat more encouraging than in much of the recent past. Employment increased significantly in a large number of countries in 1985, and virtually, all countries are expected to experience employment gains over the forecast period. Nevertheless, in many countries, particularly those in Europe, these gains will only keep pace with the number of new entrants into the labor force. The unemployment rate in those countries is therefore unlikely to decline much over the forecast period, if at all.

Total employment in the industrial countries increased by 1.4 percent in 1985, with more evenly balanced gains among countries than in 1984, when a somewhat larger rise in employment was largely attributable to developments in the United States. In the group of countries excluding the United States, employment growth accelerated from 0.3 percent in 1984 to 0.8 percent in 1985. This is the best employment performance in these countries since 1980 and compares favorably with the average employment increase in the 1970s. In the United States, even though employment growth decelerated significantly in 1985, the increase was still more than twice as fast as in the other industrial countries. The number of countries experiencing employment losses was also reduced in 1985. France was the only major country where employment declined, and this decline was much smaller than in the previous year. Among the smaller industrial countries, only Ireland and Spain suffered a loss of employment in 1985, but in these countries as well the declines were appreciably smaller than in 1984.

The principal factors underlying the turnaround in employment in the European countries appear to be the completion of a period of adjustment to earlier disturbances and a trend toward lower real wage increases in recent years. The period from 1980 to 1984 was characterized by severe labor shedding in the European countries, reflecting efforts to bring labor productivity into line with real labor costs in circumstances where the growth of total factor productivity was declining and prices of intermediate inputs were rising. As a result, the growth of labor productivity in that period was surprisingly strong, given the slow growth of output (Chart 7). With output growing at the same pace in 1985 as in 1984, the recovery of employment in the European countries reflected a smaller increase in labor productivity than in 1984. The lower growth in labor productivity seems to suggest that the process of adjustment to the disturbances of the early 1980s may be approaching an end. The moderation of real wage increases since 1982, however, also appears to have played a role by reducing the incentive of firms to substitute capital for labor in the production process. In the United States, the slowdown in employment growth in 1985 broadly matched the deceleration in output growth.

Chart 7.
Chart 7.

Industrial Countries: Growth of Output and Employment, 1975–87

(Average and annual changes, in percent)

Notwithstanding the gains in employment, the unemployment rate did not decline appreciably in the industrial countries in 1985, because demographic factors and rising participation rates led to an offsetting increase in the labor force. Canada and, to a lesser extent, the United States, were the only major countries in which unemployment fell significantly, whereas France and the United Kingdom recorded further sizable increases. In the group of smaller industrial countries, unemployment rose marginally, despite fairly significant reductions in the Scandinavian countries and in Australia. For the industrial countries of Europe overall, the combined unemployment rate rose to 11.2 percent of the labor force, compared with 10.9 percent in 1984 and 9.4 percent in 1982, when the present phase of expansion began. Since 1982, the U.S. unemployment rate has come down from 9.7 percent to about 7 percent early in 1986.

In most of the industrial countries employment is expected to grow at about the same pace over the forecast period as in 1985. In France, however, job creation is expected to increase slightly in both years after three consecutive years of decline. Employment growth in Canada and the United States is projected to remain considerably stronger than elsewhere. Among the smaller industrial countries, Australia and Denmark are projected to enjoy the strongest employment growth, while in Spain and New Zealand employment is expected to increase only marginally. The outlook for continued moderate employment growth is attributable in large measure to the same forces that led to the improvement in 1985. In particular, labor shedding in manufacturing in Europe is expected to come to a virtual halt, as continued real wage moderation permits a further improvement in profitability. In some countries, including the Federal Republic of Germany and France, faster output growth will also contribute to rising employment.

Although the expected growth in employment in 1986 and 1987 is encouraging, it may not be sufficient to reduce unemployment more than marginally in the industrial countries. North America represents the only region in the industrial world in which unemployment is expected to remain clearly on a downward path over the next two years. In the major countries of Europe, taken as a group, unemployment is expected to be stable, with a moderate decline in joblessness in the Federal Republic of Germany being offset by small increases in France and Italy. Unemployment is expected to decline modestly in the group of smaller industrial countries, mainly because of significant reductions in Australia, Denmark, and Spain. In Japan, where the level of unemployment is much lower than in the other major countries, the proportion of the labor force out of work is expected to rise to 3 percent in 1986 for the first time in recent history, and to continue to increase in 1987.

It should be emphasized that the gains in employment in Europe over the forecast period could be greater than those projected. Whether this potential is realized will depend on the extent to which increases in real labor costs moderate in response to the decline in oil prices and the improvement in Europe’s terms of trade. The decline in oil prices, together with the recent appreciation of the European currencies, will result in a substantial, albeit transitory, reduction in the rate of increase of consumer prices in comparison with the prices of domestic products. The increase in real wages measured in terms of consumer prices will therefore translate into a smaller rise in real labor costs relative to output prices—the relevant measure from the employer’s point of view. If countries take advantage of this opportunity by containing the rise in real consumption wages—that is, by limiting the extent to which the terms of trade gains are passed on to wage earners—employment can be expected to rise more than would otherwise be the case, even though such gains may show up only after some lag.

Inflation

The continuing deceleration of inflation in industrial countries more than three years into the recovery clearly distinguishes this economic cycle from previous upswings. While the business cycles of the 1960s and 1970s were characterized by a disturbing tendency for inflation rates to ratchet upward to ever higher levels, inflation has continued to moderate in the current recovery (Chart 8). In 1985, the rate of increase of the composite GNP deflator for the industrial countries slowed for the fifth consecutive year, to 3.9 percent, the lowest rate recorded since the late 1960s. Consumer price increases have followed the same overall trend in the past few years, although the deceleration has been from a rather higher level, reflecting the impact of the rise in energy prices in the early 1980s. Differences in inflation performance among countries also continued to narrow in 1985 as countries with higher-than-average inflation rates registered additional significant decelerations in price increases. Over the next two years, inflation is projected to continue to decline, and the dispersion of inflation rates across countries is expected to diminish further.

Chart 8.
Chart 8.

Major Industrial Countries: Inflation Paths from the 1970–71, 1974–75, and 1980–82 Recessions

(Change from the corresponding quarter of the previous year, in percent, beginning in trough of each recession: fourth quarter 1971, first quarter 1975, and fourth quarter 1982)

A number of factors have contributed to the good inflation performance in recent years. First and foremost has been the consistent anti-inflationary stance of government policies in general and monetary policies in particular. The authorities in most countries have made a sustained effort to curtail the growth of monetary aggregates, and to create conditions conducive to continued downward pressure on inflation and inflationary expectations. In addition, public sector wage and pricing policies, together with deregulation and industrial policies, have had a direct impact on the costs of goods and services provided by the public sector and important segments of the private sector.

The consistent commitment of the industrial countries to an anti-inflation policy has made an important contribution to the marked deceleration in nominal wage increases during the 1980s. Subsiding inflationary expectations and high unemployment rates, together with the modification or suspension of indexation clauses, have significantly reduced wage increases in recent years. For the industrial countries as a group, the rate of increase of hourly compensation in manufacturing has fallen from 11.5 percent in 1980 to 5.3 percent in 1985, with the decline being pervasive across countries. At the same time, labor productivity increased, particularly in Europe, resulting in a pronounced deceleration of unit labor cost increases. In 1983–84, for example, reflecting the strong growth of industrial production, unit labor costs in manufacturing were essentially flat in the industrial countries. These costs began to rise again as the growth of output per man-hour moderated in 1985, and their rate of increase is expected to remain at 1½ percent to 2 percent over the next two years (Chart 9). Labor costs, however, are still expected to increase less than GNP deflators, allowing some margin for a further improvement in profitability.

Chart 9.
Chart 9.

Major Industrial Countries: Indicators of Inflation, 1979–87

(Annual changes, in percent)

The weakness of import prices has also played an important role in the improved price performance in industrial countries in recent years. For the industrial countries as a group this mainly reflects the weakness in the prices of oil and other primary commodities. Following the sharp rise in 1979–80, average oil prices (measured in U.S. dollar terms) declined by 11.7 percent in 1983, and by 2.1 percent in 1984. Oil prices fell an additional 4.4 percent in 1985 and are assumed to fall by 40 percent in 1986. During the first two years of the recovery, prices of non-oil commodities recovered somewhat from a protracted decline during the recession. In 1985, however, there was a broadly based decline in commodity prices of 12.2 percent (in dollar terms) as supplies of many items increased and slower output growth limited the growth of demand.

The substantial decline in the U.S. dollar on foreign exchange markets since March 1985 should, in itself, have been a factor making for higher commodity prices in dollar terms. So far, however, further increases in supply and a considerable inventory overhang in some markets have mitigated these exchange rate influences. Although there was a substantial rise in the price of coffee in the final months of 1985, prices of other primary commodities have remained relatively weak. While non-oil commodity prices are expected to recover somewhat during 1986, their average level in real terms (measured relative to the price index for exports of manufactures) would still be about 2 percent lower than in 1985. (See Supplementary Note 3, “Non-Oil Commodity Price Developments.”) Overall, import unit values for the industrial countries as a group, after increasing in local currency terms by only 0.8 percent in 1985, are expected to fall by 7½ percent in 1986 and then to rise by 3¼ percent in 1987.

In 1985, Japan and the Federal Republic of Germany once again recorded the lowest inflation rates among the major industrial countries (Chart 10). The United States and Canada continued to consolidate the substantial reduction in their inflation rates achieved earlier. In the United Kingdom, however, a country which had also significantly lowered its inflation rate, there was some slippage in 1985. Inflation rose noticeably early in the year under the influence of a sharp depreciation of sterling and rising interest rates (which affect the consumer price index directly in the United Kingdom). By the latter half of the year, these temporary influences appeared to have subsided; nevertheless, there has been a noticeable acceleration in the rate of increase of unit labor costs over the past two years (from 1.3 percent in 1983 to 5.2 percent in 1985).

Chart 10.
Chart 10.

Major Industrial Countries: Consumer Price Inflation, 1979–87

(Annual changes, in percent)

France and Italy made further significant progress in 1985 in reducing their inflation rates. Incomes policies continue to be used as an important adjunct to monetary and fiscal policies in these countries. In France, the rate of increase of the GDP deflator fell by over 1 percentage point and consumer prices decelerated even more, reflecting in part the strengthening of the effective exchange rate in the latter half of the year. Wage increases also have decelerated significantly over the past three years, and France had one of the smallest increases in unit labor costs among the major industrial countries in 1985. The Italian inflation rate slowed by almost 1¾ percentage points on a GDP deflator basis last year, but at 9 percent it was still more than double the average rate in the other major countries. The Italian authorities took further steps in 1985 to delay and reduce the responsiveness of nominal wages to price increases under the national wage indexation scheme.

The smaller industrial countries achieved a further reduction in their inflation rates in 1985, as had been the case in 1983 and 1984. The easing of price pressures was fairly widely spread, with Austria and Spain achieving the largest declines. Nevertheless, for the smaller industrial countries as a group, inflation has remained almost 2 percentage points higher than in the major industrial countries.

The projected further improvement in inflation performance in industrial countries in 1986 is primarily attributable to the lower oil prices that are assumed to prevail. The rate of consumer price inflation is expected to decline by an additional full percentage point, with a somewhat smaller drop in the rate of increase in the combined GNP deflator. As far as the relative inflation performance among industrial countries is concerned, this will be significantly affected by recent movements in exchange rates. While the rate of increase in consumer prices is expected to decline slightly in the United States in 1986, a deceleration of almost 2¾ percentage points is projected for the European countries. As a result, in the European countries as a group, consumer price increases would be slightly lower than in the United States, after having significantly exceeded the U.S. inflation rate in every year since 1980.

The projections for 1987 are somewhat more tenuous; however, no significant changes in inflation trends are anticipated even though the effects of the reduction in oil prices are expected to continue to dampen price pressures. Since exchange rates are assumed constant from early March 1986, changes in consumer prices will not be further influenced by this factor. Overall, the rate of increase of consumer prices is expected to rise slightly in Europe and Japan in 1987, as the immediate benefits from terms of trade gains are absorbed in the price level.

Exchange Market Developments

The U.S. dollar, after four consecutive years of strong appreciation, depreciated significantly beginning in March 1985. For the 12 months through March 1986, the depreciation amounted to almost 25 percent in nominal effective terms (Chart 11). Correspondingly, most of the currencies of the other major industrial countries appreciated against the U.S. dollar in nominal effective terms. Most notably, the effective rate of the Japanese yen rose by 24 percent and that of the deutsche mark by 13 percent. These exchange rate movements brought the real effective exchange rate of the three largest industrial countries closer to their average values for the 1975–84 decade (Chart 12). Based on nominal exchange rate values and on extrapolations of normalized unit labor costs, in the first quarter of 1986, the real exchange rate of the U.S. dollar was 8 percent above its average value for the past decade, that of the deutsche mark 6 percent below its average, and that of the Japanese yen above its average value by 3 percent.

Chart 11.
Chart 11.

Major Industrial Countries: Indices of Monthly Average U.S. Dollar and Effective Exchange Rates, January 1982–February 1986

(Indices: average value for 1975–84 = 100)

Chart 12.
Chart 12.

Major Industrial Countries: Relative Prices of Manufactures Adjusted for Exchange Rate Changes, 1982–86

(Indices: average value for 1975–84= 100)1, 2

Source: IMF, International Financial Statistics.1 Indices of the type shown here are frequently referred to as indices of real effective exchange rates.2 The data for fourth quarter 1985 and the first quarter 1986 are based on preliminary Fund staff estimates.3 Annual deflators for gross domestic product originating in manufacturing with quarterly interpolations and extrapolations (beyond the latest available data) based on wholesale price data for manufactures.

The depreciation of the U.S. dollar followed a steep rise from mid-November 1984 through the latter part of February 1985 that capped the seemingly interminable appreciation that had begun in the third quarter of 1980. The reasons for the turnaround appear to be rooted in several developments that began during the second half of 1984. First, short-term interest rate differentials had generally moved against dollar-denominated assets from August 1984 through January 1985. Although these movements were partially reversed during the next two months, the net changes remained substantial (Chart 13). Second, growth of the narrow monetary aggregate in the United States (M1) had accelerated considerably beginning in November 1984, and by March 1985 it had moved outside the target range. The continuation of rapid growth after the breaching of the upper limit of the target range may have contributed to a view that monetary policy was in fact being relaxed. Third, there were a number of signs indicating a slowing of real economic growth in the United States, while the rate of expansion was showing little change on average in other large industrial countries. Fourth, there may have been a speculative bubble affecting the value of the dollar during the months leading up to February 1985, which then ran its course, contributing to the subsequent decline; the timing of this effect appears to have been influenced by sizable coordinated intervention at the end of February.

Chart 13.
Chart 13.

Major Industrial Countries; Monthly Average Short-Term Interest Rates, January 1982–February 19861

(In percent per annum)

1 The rates shown are monthly averages of daily rates on money market instruments of about 90 days’ maturity, except for Japan, where the discount rate on 2-month (private) bills is used.

From March through August 1985, the U.S. dollar depreciated by 19 percent against the deutsche mark and by 9 percent against the Japanese yen. Even so, both the deutsche mark and the yen were still well below their average levels of the preceding decade in real terms, and the prospective current account surpluses of the Federal Republic of Germany and Japan remained large.

The exchange rate movements that had taken place from March through August were given a further impetus in the aftermath of the September meeting of Finance Ministers and Central Bank Governors of the Group of Five countries (the United States, Japan, the Federal Republic of Germany, the United Kingdom, and France). It was agreed at that meeting that a further appreciation of the non-dollar currencies against the dollar would be desirable, inasmuch as it was thought that the current levels did not fully reflect changes in policy and in underlying economic conditions that had already taken place or that were in prospect. Consequently, the Group of Five countries—in cooperation with the other countries constituting the Group of Ten (Italy, Canada, the Netherlands, Belgium, Sweden, and Switzerland)—undertook sizable coordinated intervention in foreign exchange markets throughout the remainder of the year.

The September 1985 Group of Five meeting was also followed by a temporary shift toward a somewhat tighter monetary stance in Japan. Domestic short-term interest rates rose from about 6½ percent—a level that had prevailed since the latter part of 1983—to around 8 percent in late October. However, early in 1986, when it became clear that the resultant strengthening of the yen would not be reversed, interest rates were allowed to fall back to and below their September levels. By early March, after the central banks of Japan, United States, and Germany all implemented similar cuts in the discount rate, the differentials among domestic short-term market interest rates in those three countries were roughly at the same level as at the time of the September Group of Five meeting.

Reflecting the developments just described, the U.S. dollar depreciated sharply against all other major currencies following the Group of Five meeting. Subsequently, the markets settled down; overall, from September through March 1986, the depreciation of the U.S. dollar in effective terms was somewhat larger than that which took place between March and September 1985 (Chart 11). However, the pattern of bilateral exchange rate movements changed in the post-meeting period, with the Japanese yen showing a more substantial appreciation against the dollar (over 27 percent from September 20, 1985 to late March 1986, compared with about 21 percent for the deutsche mark).

Another factor that may have helped to push the exchange rates of the larger countries toward more sustainable levels during the latter part of 1985 and the first quarter of 1986 was the improved prospect for fiscal restraint in the United States. Divergences in fiscal policy had been a major factor behind the dollar’s appreciation in the early 1980s. Thus the elimination or reversal of this divergence would be expected to work in the opposite direction.

Until the latter part of 1985, the course of U.S. fiscal policy had proved difficult to change. The Congressional Budget Resolution in August provided a first indication that a change in policy was under way. Then, in December, the enactment of the Gramm-Rudman-Hollings balanced budget act mandated gradual reductions in fiscal deficits beginning in the current fiscal year and extending through fiscal year 1991. (The expected economic effects of the legislation on the United States and on other countries are discussed more fully in Chapter IV “Policy Interactions in Industrial Countries.”) The decline in long-term interest rates in the United States—from 12 percent in March 1985 to 9 percent in February 1986—may in large measure have been a response to improving prospects for effective action to reduce the deficit, especially toward the end of this period.

The large decline in oil prices during the first quarter of 1986 also reinforced these movements in the exchange rates of the currencies of the major industrial countries. The fall in oil prices appears to have strengthened relatively the external positions of Japan and a number of European countries, and it helped to accelerate the appreciation of the currencies of those countries with respect to the U.S. dollar during February and March 1986. Although the United States is also a large oil importer, it is relatively less dependent on foreign oil supplies, and would benefit less from a drop in oil prices. Over a longer time horizon, however, trade in other commodities will also be affected as lower export earnings from oil exporters are translated into lower imports from industrial countries. This effect could mitigate these exchange market implications somewhat.

The depreciation of the dollar during 1985 does not appear to have resulted in severe pressure on the parities within the European Monetary System (EMS) until around the end of the year (Chart 14). This relative smoothness was perhaps surprising in view of the fact that movements out of the dollar have in the past tended to go predominantly into deutsche mark. It may be that the potential for tensions within the EMS has been reduced in recent years by the convergence of production cost increases among most member countries, although it also appears that substantial intervention was required on a number of occasions.

Chart 14.
Chart 14.

European Monetary System: Relative Positions of the Currencies Participating in the Narrow Band, 1985–861

(In percent)

Sources: IMF Data Fund; and Fund staff calculations.1 Based on weekly averages, January 6, 1985 to March 21, 1986. The vertical distance between any two currencies is equal to the percentage deviation from their bilateral central parity rate.

One EMS realignment was undertaken, in July, when the Italian lira was devalued by 6 percent against the European Currency Unit (ECU) and the other participating currencies were revalued by 2 percent. Among the countries adhering to the narrow EMS band, the Belgian franc was the weakest currency during most of the year (Chart 14). Major pressures, however, were avoided through intervention and through occasional tightening of the stance of monetary policy.

The pound sterling, which had depreciated by over 12 percent in nominal effective terms during 1984, fell by a further 3½ percent in January 1985, until a sharp rise in domestic interest rates halted the decline. Once the dollar began to decline broadly in March, the pound appreciated strongly in effective terms, rising by 16 percent in nominal effective terms from January to July. Thereafter, sterling began to weaken again in effective terms. Downward pressure on the pound became quite strong toward the end of 1985 and early in 1986 in anticipation of (and then in response to) lower oil prices. It is noteworthy, however, that the real value of the pound (measured by reference to normalized unit labor costs) remains high by historical comparison, especially vis-à-vis the EMS currencies. In March 1986, for example, the real bilateral rate with respect to the deutsche mark is estimated to have been almost 15 percent above the 1975–84 average.

The Canadian dollar depreciated by 5½ percent against the U.S. dollar during 1985 and the first quarter of 1986, and by about 13 percent in both nominal and real effective terms. While the Canadian dollar had been depreciating steadily against the U.S. dollar for a number of years, until early in 1985 it had been appreciating quite strongly against other currencies. The fact that the Canadian dollar did not share, even in some degree, in the general appreciation of currencies against the U.S. dollar appears to have been associated with a decline in interest differentials and also with difficulties experienced by some small banking institutions. Interest differentials favoring investment in Canadian-dollar-denominated assets over those in U.S. dollars fell from 2½ percent in March 1985 to 1 percent in November 1985, reflecting the intention of the Canadian authorities to accommodate domestic economic expansion as long as there were no strong pressures on the exchange rate or on inflation. However, interest differentials widened abruptly early in 1986—reaching 4 percent in February—in response to the downward pressure on the Canadian dollar. This pressure was reinforced by the decline in oil prices.

The largest exchange rate movements among the smaller industrial countries during 1985 involved the Australian and New Zealand dollars. Both of these currencies are independently floating.3 During 1985, the Australian dollar depreciated by 26 percent, reflecting in part the persistence of a large current account deficit. This deficit, approximately 5 percent of GDP in 1985, has brought external debt to a level equivalent to about one third of GDP. The New Zealand dollar appreciated by 15 percent in real effective terms between January and November 1985, reflecting in part sharp increases in domestic interest rates and the consequent emergence of a large interest rate differential in favor of assets denominated in New Zealand dollars. This appreciation reversed most of the gains in competitiveness that had followed the devaluation of July 1984. A sharp drop of the New Zealand dollar in December, however, associated with lower interest rates and a weaker economic outlook, left it at a level similar to that of the beginning of the year.

Balance of Payments Developments

The combined current account deficit of the industrial countries (including official transfers) narrowed by $10 billion in 1985 to an estimated $54 billion (Statistical Appendix Table A31). During the same period, the combined current account deficit of developing countries narrowed by $2 billion to $33 billion, while the current account of other countries is estimated to have shifted from a surplus of $2.3 billion in 1984 to a deficit of a similar magnitude in 1985 (Statistical Appendix Table A30). Thus, the large statistical discrepancy, which reflects either under-recorded surpluses, or over-recorded deficits, or some combination of the two, decreased by $7 billion to about $90 billion.4

These developments in current account positions took place in an environment of sluggish growth of world trade and falling trade prices. While the combined dollar value of overall merchandise trade by the industrial countries grew by about 3 percent from 1984 to 1985, the value of overall trade of the developing countries fell in value by a similar magnitude. In contrast, in 1984 the dollar value of total world trade expanded by over 6 percent. At least three major factors were responsible for the slowdown in world trade. First, the pace of economic expansion was slower in both the industrial and the developing countries. Among the industrial countries, the slowdown was concentrated in the United States, where the increase in total domestic demand declined from 8.5 percent in 1984 to 2.8 percent in 1985. Second, slower economic expansion and further conservation measures in the industrial countries contributed to a fall in both the volume and price of oil exports from the oil exporting countries. This decline implied a significant drop in the export revenue of these countries and hence their imports as well. Third, mainly reflecting excess supply conditions, primary commodity prices fell by an average of 12.2 percent from 1984 to 1985. Consequently, the terms of trade of most developing countries deteriorated significantly, contributing to the contraction in the value of their total trade.

One of the major factors contributing to the generally improved current account positions of the industrial countries in 1985 was a decline in the value of oil imports. This decline was explained almost equally by the reduction in the price of oil and by the continued reduction in oil consumption by the major importing countries. These developments in turn reflected mainly the slowing of economic growth in the industrial countries, but also the continuing effects of conservation measures and a further substitution of other forms of energy for oil.

The current account positions of the United States and Japan continued to diverge in 1985, albeit at a slower pace than in the past several years (Chart 15). The deficit of the United States widened by about $10 billion, to $118 billion (2.8 percent of GNP), while Japan’s surplus increased by $15 billion, to $50 billion (3.7 percent of GNP). The extent of deterioration in the deficit of the United States was much less pronounced than in the previous two years. It is also significant that the current account surplus of the Federal Republic of Germany increased by over $6 billion, to an estimated $13 billion (2.1 percent of GNP). Among other major industrial countries showing an external improvement, the current account surplus of the United Kingdom rose from $1.1 billion in 1984 to $3.8 billion in 1985 (owing in part to the ending of the miners’ strike), while the current account position of France shifted from a deficit of $0.8 billion to a small surplus. On the other hand, Italy’s current account deficit widened by about $0.7 billion, and the position of Canada turned from a surplus of $2 billion into a deficit of $1.9 billion. The current account positions of the smaller industrial countries either strengthened marginally or were essentially unchanged from 1984 to 1985. The major exceptions were Sweden, where the current account position deteriorated from a small surplus to a deficit of $1.3 billion, and Denmark, where the deficit widened from $1.7 billion in 1984 to $2.6 billion in 1985.

Chart 15.
Chart 15.

Major Industrial Countries: Payments Balances on Current Account, Including Official Transfers, 1982–85

(In percent of GNP)

Cyclical factors and terms of trade changes both played important parts in the current account developments of the United States and Japan during 1985. In the United States, the rate of growth of real domestic demand fell sharply in 1985, as noted above, while the growth of foreign demand was virtually unchanged. Reflecting this, the rate of growth in the volume of U.S. imports dropped from 29 percent to less than 7 percent, with a small decline in the volume of exports. An improvement in the terms of trade of some 4 percent served to limit further the deterioration in the U.S. current account. For Japan, the sharp slowdown in the rate of growth of export markets (amounting to 7 percentage points) was reflected in a decline in export volume growth from 16 percent in 1984 to 5 percent in 1985. However, since imports stagnated and lower oil and commodity prices resulted in a 4 percent improvement in the terms of trade, the Japanese current account surplus widened substantially.

Terms of trade changes played a more limited role in the current account developments of the other industrial countries. For Canada, the terms of trade even deteriorated somewhat, reflecting its position as a net exporter of primary commodities and the continued weakness of the Canadian dollar. Slower demand expansion in the United States and rapid expansion domestically further contributed to the deterioration of Canada’s current account. For the remaining industrial countries, changes in current account positions in 1985 seem to have largely reflected the lagged effects of shifts in competitive positions in earlier years. The improvement in the current account positions of the Federal Republic of Germany, France, and the United Kingdom mirrored the cumulative real depreciation of their currencies during 1984 and early 1985; the deutsche mark depreciated by 7 percent, the pound sterling by 5 percent, and the French franc by over 2 percent from the first quarter of 1984 to the first quarter of 1985. Similarly, the deterioration in the current accounts of Italy and Sweden was associated with the real appreciation of their currencies during 1984, amounting to 2 percent and 4 percent, respectively.

Factors underlying developments in non-oil trade positions are illustrated in Chart 16, which shows indices of the real non-oil trade balance (non-oil export volumes relative to non-oil import volumes), the real effective exchange rate, domestic demand, and foreign demand. As the chart indicates, the large shifts in these major industrial countries’ competitive positions that took place from 1981 to 1984 began to be reversed during 1985. These reversals in relative competitive positions did not immediately translate into corresponding shifts in current account positions during 1985. It is expected, however, that the effects will begin to be felt on trade flows during 1986 and, more strongly, in 1987.

Chart 16.
Chart 16.
Chart 16.

Major Industrial Countries: Real Non-Oil Trade Balances and Determinants, 1981–85

(Indices: first half of 1981 = 100)

1 The real effective exchange rate is measured as relative normalized unit labor costs adjusted for exchange rate changes.2 The real non-oil trade balance is an index of non-oil export volumes divided by an index of non-oil import volumes.3 Real total domestic demand.4 Real total domestic demand in foreign markets weighted by the share of each market in the indicated country’s exports.

Another striking feature of developments underlying non-oil trade balances during 1985 was a narrowing of growth differentials among the major industrial countries, largely reflecting the slowdown in economic activity in the United States. From 1982 to 1984, the growth of foreign demand was greater than that of domestic demand in all countries except the United States and the United Kingdom. For example, the rate of growth of domestic demand in Japan, the country with the fastest GNP growth outside of the United States during 1982–84, averaged just 3 percent in 1982–84, compared with a rate of growth of foreign markets of 4½ percent. Conversely, in the United States the rate of growth of domestic demand during the same period averaged close to 7 percent, compared with foreign market growth of a little over 2 percent. From 1984 to 1985, however, the rate of growth of domestic demand in the United States decreased to 3 percent, while the rate of growth of U.S. export markets increased at about the same pace. In the industrial countries of Europe, reflecting the high share of trade among European countries, domestic and foreign demand moved more closely together. These cyclical changes seem to have already had some impact on current account developments in 1985, and they are expected to continue to influence developments throughout 1986, as a further convergence of domestic and foreign demand growth is expected over the coming months.

The divergence in current account positions of the United States and Japan and, to a lesser extent, the Federal Republic of Germany during 1982–85 have corresponded to large net private capital inflows into the United States and large net outflows from the other two countries. In the United States most increases in net capital inflows took the form of changes in banking flows during the early part of the period and, increasingly, securities in transactions during more recent months. On a gross basis, the increase in U.S. banks’ foreign liabilities declined steadily from $66 billion in 1982 to $32 billion in 1984, while net foreign purchases of U.S. securities rose from $13 billion in 1982 to $35 billion in 1984. In 1985, the increase in U.S. banks’ foreign liabilities rose somewhat to $41 billion, while net foreign purchases of U.S. securities continued to rise to an estimated $72 billion. In Japan, increases in residents’ purchases of foreign securities more than accounted for the increase in net outflows of longterm capital, which rose from $50 billion in 1984 to $64 billion in 1985.

Projections of balance of payments developments in 1986–87 have been made on the basis of the working assumption that real exchange rates among major countries will remain unchanged from the pattern prevailing in early March 1986. Oil prices are assumed to average $16 per barrel in 1986 and $15 per barrel in 1987. On this basis, the combined current account position of industrial countries is projected to improve by some $68 billion to a surplus of $14 billion in 1986, reflecting largely more favorable terms of trade. The U.S. payments position in the coming period will be favorably affected by the lagged effects of recent changes in competitiveness (the consequence of the falling dollar) and by lower oil and commodity prices. The latter development is expected to generate a terms of trade improvement for the United States of 3 percent in 1986. The depreciation of the dollar is expected to contribute to a strengthening of the invisibles balance, as direct investment receipts are projected to rise significantly faster than net interest payments in 1986. Cyclical factors will be broadly neutral, as the rate of growth of domestic demand is expected to be similar in the United States and in its major trading partners. However, since U.S. imports are already so much larger than exports, there is an underlying tendency for the current account deficit to widen, even when imports and exports are growing at the same pace. The net effect of these factors is expected to lead to a U.S. current account deficit in 1986–87 that is somewhat smaller (at 2.5 percent relative to GNP) than that recorded in 1985 (2.9 percent).

In the other industrial countries, competitiveness has deteriorated somewhat as a result of the falling dollar. For the short term, however, “J-curve” effects are likely to cause a continued strengthening in current account positions expressed in U.S. dollars. Lower oil and commodity prices will also tend to increase the aggregate current surplus of industrial countries outside the United States. Looking further ahead, however, recent developments in exchange rates are expected to exert a growing influence on trade flows in volume terms. At the same time, financial constraints facing oil exporting countries will probably lead to significant cutbacks in their imports from the industrial world. The net effect of these factors for European countries is to produce a substantial increase, in dollar terms, in their current account surpluses in 1986, followed by a moderate erosion. A similar pattern is projected for Japan, whose current account surplus is expected to reach 3.9 percent of GNP in 1986, before declining to 3.1 percent of GNP in 1987. For the Federal Republic of Germany, the corresponding figures would be 2.9 percent and 2.2 percent, respectively.

Uncertainties in the Projections

The projections presented in the foregoing sections constitute the staffs view of the most likely outcome for the industrial countries. It is important to recognize, however, that a significant margin of uncertainty attaches to any point estimate of future economic developments: both policies and behavior by individuals and enterprises may turn out to be different from the assumptions adopted in elaborating the projections. At the present time, the most important uncertainties for the industrial countries are those that surround the behavior of the business cycle, the policy stance to be adopted by major countries, the evolution of exchange rates, and developments in oil prices.

The Business Cycle

An important feature of the projections is the relatively smooth continuation of the recovery at a pace that is expected to be broadly similar to the rate of growth of potential output in the industrial countries as a whole. Historically, however, recoveries that have reached the same maturity as the present one—about three years—have typically started showing signs of strain, with output approaching capacity and inflation beginning to pick up. In such circumstances economic policy has often been tightened, which together with declining profits and procyclical movements in saving ratios, inventories, and investment has generated a new cyclical downturn, frequently in the fourth or fifth year after the start of an upswing. A repetition of this type of cyclical pattern cannot be excluded. Nevertheless, there are a number of factors that justify a more optimistic view. First, inflation has continued to decelerate, and the outlook for high-inflation countries in particular continues to point to the likelihood that inflation will moderate further. Second, capacity utilization, though tending to rise, has not yet approached the point where bottlenecks seem likely to impede the growth of demand (Chart 17). Since the outlook for business investment continues to be favorable, there is a reasonable prospect that capacity will grow sufficiently rapidly to prevent the short-term re-emergence of constraints. Third, the terms of trade gains of industrial countries will stimulate real incomes while moderating the growth of producers’ costs.

Chart 17.
Chart 17.

Major Industrial Countries: Rates of Capacity Utilization in Manufacturing

Sources: OECD, Main Economic Indicators: Ministry of Inter-national Trade AND Industry. Japan; Industrial Statistics Monthly; Commission of the European Communities. European Economy. Supplement B.1 Canada. United States, Federal Republic of Germany: third quarter 1985: Japan: November 1985; FrANCE. United Kingdom: October 1985: Italy: fourth quarter 1985.2 Index: historical peak = 100.

Adaptation of Economic Policies

The assumptions underlying the projections suggest that the setting of policies in the major industrial countries is undergoing a number of changes which have reduced, if not eliminated, some of the main negative risks in the outlook. In some countries that have already made substantial progress in eliminating imbalances, the stance of fiscal policy in 1986 is expected to be somewhat less restrictive, while countries that have postponed policy adaptations have started implementing the necessary measures. Beneficial effects of these policy adjustments have already materialized in the form of a significant realignment of exchange rates and easier monetary conditions. Despite these developments, a number of uncertainties remain with regard to the continued adaptation of economic policies.

The speed of implementation of the objective of balancing the federal budget in the United States, in particular, could have substantial implications for the performance of the United States and other countries in 1987 and beyond. On the one hand, major slippages in reducing the budget deficit could be expected to cause interest rates to rise, with unpredictable consequences for exchange rates. Under these conditions, confidence could be expected to deteriorate, triggering a contraction of business and residential investment, which might result in a generalized slowdown. A slowdown caused by rising interest rates could be particularly serious for the developing countries’ ability to service their debt. Alternatively, a more rapid implementation of the deficit reductions than assumed in the projections might also lower growth, at least in the short run. This would depend in part on the impact on financial conditions, and on the interest elasticity of demand, as well as on the response of other countries. (These issues are discussed in detail in Chapter IV, “Policy Interactions in Industrial Countries.”)

Exchange Rates

The exchange rate of the U.S. dollar remains a major element of uncertainty. The agreement among the Group of Five countries last September to encourage exchange rates of key currencies to move more closely into line with underlying “fundamentals” has been successful in achieving a substantial depreciation of the dollar vis-à-vis the yen and the EMS currencies. At the same time, the likelihood of a new sharp appreciation of the dollar has diminished, if not disappeared. However, given the high import propensity of the United States, together with the existing gap between exports and imports and the rise in net investment income to other countries, the maintenance of the real external value of the dollar at its March 1986 level is estimated to be sufficient only to stabilize the current account. The amount of dollars in foreign investors’ portfolios would therefore continue to increase at a rate of over $100 billion a year. Since there must be some doubt about the willingness of foreign investors to finance the U.S. current account deficit indefinitely at current exchange rates and interest rates, the dollar may well depreciate further at some stage. This could take the form of a gradual adjustment over time—as assumed in the medium-term baseline scenario discussed in Chapter IV on “Policy Interactions in Industrial Countries.” Alternatively, sudden changes in investors’ confidence might generate a sharper depreciation; the likelihood of such an eventuality would appear to be higher in the absence of deficit-reducing measures in the United States. (The possible implications of a further depreciation of the dollar are also discussed in Chapter IV.)

Oil Prices

The effects of the substantial declines in oil prices that had occurred by early 1986, and the future development of these prices, are of considerable importance in gauging economic prospects in industrial countries. The projected decline in the fuel exporting countries’ export earnings is expected to be partly reflected in lower imports of these countries, which explains the projected sizable deterioration of the industrial countries’ real net exports in 1986.

The staffs projections have been developed on the basis of oil prices averaging $16 per barrel in 1986 and $15 per barrel in 1987. This represents a decline of 40 percent in 1986 in U.S. dollar terms from the average 1985 level, and an even greater decline in real terms. As discussed above, this price drop is expected to have a significant favorable effect on real incomes and inflation in the industrial countries—probably cutting an average of 1 to 1½ percent per annum off the combined rate of inflation in the Consumer Price Index in 1986–87 and adding ½ to 1 percent to the level of aggregate output at the end of the forecast period, compared with what otherwise would have been projected.

The projections have been elaborated on the assumption that the oil price change is sustained, or at least perceived to be lasting by market participants. To the extent that the price change was perceived to be transitory, the effects would of course become smaller and, in the limit, would tend to disappear altogether. While the fuel exporting countries would have a strong incentive to finance rather than adjust to the temporary weakening of their external positions, energy users in the fuel importing countries would tend to save a high proportion of the transitory rise in real incomes, thus helping to generate the financing required by the fuel exporting countries. Such financing might, however, not be forthcoming for some of the capital importing fuel exporters, even if it was generally agreed that the price change was temporary. If so, the decline in these countries’ imports would probably exceed the expansionary effects in oil importing countries, so that even the latter countries might end up worse off from a temporary fall in the price of oil.

Similarly, adverse effects would follow if oil prices were to become much more variable in the future than they have been in the past. If oil prices were henceforth to fluctuate randomly between, say, $15 and $25 a barrel, this would be equivalent to a succession of shocks to the world economy equivalent to well over of 1 percent of GNP. Shocks of this magnitude could be seriously destabilizing, and it would presumably be a matter of time before countries took action to insulate themselves from them. Fuel importing countries might impose variable levies on oil imports so as to neutralize the effect on domestic energy prices and real incomes. To the extent that domestic prices continued to fluctuate, consumers might be expected to respond with increases in saving rates so as to better cope with the increased variability of their prospective real income streams. Similarly, fuel exporting countries would respond by building up reserves so as to better cope with the increased variability of their prospective export earnings. Aggregated across all countries, the result would be a general rise in world savings as countries sought to cope with the increase in the variability of real incomes. That rise would have a net deflationary effect on the world economy, at least in the short run.

Another set of costs associated with oil price changes is the adjustment costs associated with sustained oil price changes. The oil price increases of the 1970s resulted in large capital losses for oil importing countries as large parts of the capital stock became obsolete given the new and largely unquestioned set of relative prices. More generally, the changes in relative prices induced a large-scale and costly reallocation of resources. Additional costs were incurred by oil importing countries in the form of the output forgone as national authorities in these countries sought to reestablish a non-inflationary environment for sustained growth. By the same token, the price declines since 1980 and especially those of the last year have resulted in a renewed string of capital losses and, potentially, a renewed set of adjustment costs. The most obvious of these are the large energy-related investments made by countries in, for example, oil exploration and extraction, nuclear and hydroelectric energy, strategic petroleum reserves, and new or “alternative” energy sources. Some of these investments were viable only on the assumption that energy prices would remain significantly above present levels.

These adjustment costs tend to get ignored in flow-oriented analyses. Such analyses often conclude that neither the level nor the distribution of world income would be much affected by a sustained change in oil prices that was later reversed. This ignores, however, the fact that because of adjustment costs, global wealth ends up lower under the hypothesized conditions than it would have if actual (or expected) relative prices had not changed.

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Cover World Economic Outlook, May 1986
World Economic Outlook, May 1986
Author: International Monetary Fund. Research Dept.
ISBN:
9781451944785
ISSN:
0256-6877
Publication Date:
01 Jan 1986
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781451944785.081
Pages:
278
  • View in gallery

    Major Industrial Countries: Fiscal Impulses, 1982–85 and 1986–871

    (In percent of GDP/GNP at annual rates)

  • View in gallery

    Major Industrial Countries: Money Supply, Nominal GNP, and GNP Deflator, 1970–87

    (Annuai changes, in percent)

  • View in gallery

    Five Major Industrial Countries: Interest Rates, 1980–86

    (In percent)

  • View in gallery

    Major Industrial Countries: Recovery of Real GNP from the 1970–71, 1974–75, and 1980–82 Recessions

    (Indices: fourth quarter 1971, first quarter 1975, and fourth quarter 1982= 100) 1

  • View in gallery

    Major Industrial Countries: Recovery of Real Total Domestic Demand from the 1970–71, 1974–75, and 1980–82 Recessions

    (Indices: fourth quarter 1971, first quarter 1975, and fourth quarter 1982= 100) 1

  • View in gallery

    Industrial Countries: Growth of Output and Employment, 1975–87

    (Average and annual changes, in percent)

  • View in gallery

    Major Industrial Countries: Inflation Paths from the 1970–71, 1974–75, and 1980–82 Recessions

    (Change from the corresponding quarter of the previous year, in percent, beginning in trough of each recession: fourth quarter 1971, first quarter 1975, and fourth quarter 1982)

  • View in gallery

    Major Industrial Countries: Indicators of Inflation, 1979–87

    (Annual changes, in percent)

  • View in gallery

    Major Industrial Countries: Consumer Price Inflation, 1979–87

    (Annual changes, in percent)

  • View in gallery

    Major Industrial Countries: Indices of Monthly Average U.S. Dollar and Effective Exchange Rates, January 1982–February 1986

    (Indices: average value for 1975–84 = 100)

  • View in gallery

    Major Industrial Countries: Relative Prices of Manufactures Adjusted for Exchange Rate Changes, 1982–86

    (Indices: average value for 1975–84= 100)1, 2

  • View in gallery

    Major Industrial Countries; Monthly Average Short-Term Interest Rates, January 1982–February 19861

    (In percent per annum)

  • View in gallery

    European Monetary System: Relative Positions of the Currencies Participating in the Narrow Band, 1985–861

    (In percent)

  • View in gallery

    Major Industrial Countries: Payments Balances on Current Account, Including Official Transfers, 1982–85

    (In percent of GNP)

  • View in gallery View in gallery

    Major Industrial Countries: Real Non-Oil Trade Balances and Determinants, 1981–85

    (Indices: first half of 1981 = 100)

  • View in gallery

    Major Industrial Countries: Rates of Capacity Utilization in Manufacturing

Major Industrial Countries: Fiscal Impulses, 1982–85 and 1986–871

(In percent of GDP/GNP at annual rates)

Major Industrial Countries: Money Supply, Nominal GNP, and GNP Deflator, 1970–87

(Annuai changes, in percent)

Five Major Industrial Countries: Interest Rates, 1980–86

(In percent)

Major Industrial Countries: Recovery of Real GNP from the 1970–71, 1974–75, and 1980–82 Recessions

(Indices: fourth quarter 1971, first quarter 1975, and fourth quarter 1982= 100) 1

Major Industrial Countries: Recovery of Real Total Domestic Demand from the 1970–71, 1974–75, and 1980–82 Recessions

(Indices: fourth quarter 1971, first quarter 1975, and fourth quarter 1982= 100) 1

Industrial Countries: Growth of Output and Employment, 1975–87

(Average and annual changes, in percent)

Major Industrial Countries: Inflation Paths from the 1970–71, 1974–75, and 1980–82 Recessions

(Change from the corresponding quarter of the previous year, in percent, beginning in trough of each recession: fourth quarter 1971, first quarter 1975, and fourth quarter 1982)

Major Industrial Countries: Indicators of Inflation, 1979–87

(Annual changes, in percent)

Major Industrial Countries: Consumer Price Inflation, 1979–87

(Annual changes, in percent)

Major Industrial Countries: Indices of Monthly Average U.S. Dollar and Effective Exchange Rates, January 1982–February 1986

(Indices: average value for 1975–84 = 100)

Major Industrial Countries: Relative Prices of Manufactures Adjusted for Exchange Rate Changes, 1982–86

(Indices: average value for 1975–84= 100)1, 2

Major Industrial Countries; Monthly Average Short-Term Interest Rates, January 1982–February 19861

(In percent per annum)

European Monetary System: Relative Positions of the Currencies Participating in the Narrow Band, 1985–861

(In percent)

Major Industrial Countries: Payments Balances on Current Account, Including Official Transfers, 1982–85

(In percent of GNP)

Major Industrial Countries: Real Non-Oil Trade Balances and Determinants, 1981–85

(Indices: first half of 1981 = 100)

Major Industrial Countries: Real Non-Oil Trade Balances and Determinants, 1981–85

(Indices: first half of 1981 = 100)

Major Industrial Countries: Rates of Capacity Utilization in Manufacturing