World output growth is expected to increase further, to about 4½ percent, in 1997 and to remain at this rate in 1998, projections that arc slightly higher than those in the October 1996 World Economic Outlook. Relatively solid growth is expected in the United States and the United Kingdom, although in both countries there is a risk of inflationary pressures emerging. In Canada, where there is considerable economic slack, the expansion is expected to gain momentum. In Japan, recovery is expected to continue at a moderate pace. Declines in interest rates over the past two years and the return of exchange rates to more competitive levels are expected to support recovery in Germany, France, and elsewhere in continental Europe, although continuing fiscal consolidation and weaknesses in consumer and business confidence pose downside risks. Growth in the newly industrialized economies of Asia should also pick up slightly in 1998, as exports recover from the recent slowdown.

World output growth is expected to increase further, to about 4½ percent, in 1997 and to remain at this rate in 1998, projections that arc slightly higher than those in the October 1996 World Economic Outlook. Relatively solid growth is expected in the United States and the United Kingdom, although in both countries there is a risk of inflationary pressures emerging. In Canada, where there is considerable economic slack, the expansion is expected to gain momentum. In Japan, recovery is expected to continue at a moderate pace. Declines in interest rates over the past two years and the return of exchange rates to more competitive levels are expected to support recovery in Germany, France, and elsewhere in continental Europe, although continuing fiscal consolidation and weaknesses in consumer and business confidence pose downside risks. Growth in the newly industrialized economies of Asia should also pick up slightly in 1998, as exports recover from the recent slowdown.

Activity is projected to strengthen among the developing countries of the Western Hemisphere, as the recovery from the 1995 Mexican crisis continues, while growth in Africa should remain close to its improved rate in 1996, reflecting further progress with stabilization and reform. Sustained growth at about 8 percent is expected in the developing countries of Asia, while recovery is likely to weaken slightly in the Middle East and Europe region, where conditions remain mixed. For the countries in transition, the growth outlook for 1997 is somewhat weaker than perceived last October, but recovery is still expected to broaden as an increasing number of countries reap the benefits of sustained stabilization and reform efforts.

Inflation remained subdued during 1996 in the advanced economies and declined further in the developing and transition countries, despite a sharp increase in oil prices. The IMF’s index of commodity prices rose by about 5 percent in U.S. dollar terms in 1996, with an increase of about 20 percent in the price of crude petroleum partly offset by a 1 percent decline in the prices of nonfuel primary commodities (Chart 4).2 For petroleum prices, the low levels of stocks in the aftermath of the unusually harsh 1995–96 winter season in the Northern Hemisphere exacerbated the impact of increased demand for heating oil, particularly in the second half of 1996 (Box 3). After peaking in mid-January 1997, petroleum prices fell by about 23 percent by the end of February owing to stronger world oil production and improved inventory levels, and remained near this level through the end of March. With no other upward pressures evident, petroleum prices by the end of 1997 are expected to be about 20 percent lower than at the end of 1996.

Chart 4.
Chart 4.

Commodity Price Indices1

(In US. dollars: 1990 = 100)

Petroleum prices increased during 1996 but are expected to be lower in 1997.

1 Shaded area indicates IMF staff projections.2 The weights are 57.7 percent for the index of nonfuel primary commodities and 42.3 percent for the index of petroleum prices.

Economic Activity, Inflation, and Policy Stances in Advanced Economies

Following the 1995 slowdown in most major industrial countries, a more uneven pattern of economic growth developed in 1996 (Chart 5). In the United States, hesitant growth during 1995 gave way to more solid expansion in 1996, in part reflecting the response to lower interest rates. In Japan, the economic recovery gained momentum in late 1995 and early 1996 and while erratic maintained a moderate underlying pace. In Canada, expansion picked up in the second half of 1996 after 18 months of weak growth; markedly lower interest rates and improved confidence are helping to spur the recovery. In the United Kingdom, growth during 1996 was significantly stronger than in the preceding year, raising concerns about the buildup of inflationary pressures. In contrast, 1996 brought renewed sluggishness in economic activity for continental Europe, In a number of countries, including Germany and France, weak consumer and business confidence persisted, industrial production stagnated, and unemployment continued to increase to new postwar records. By year-end, however, with lower interest rates and the return of exchange rates to more competitive levels, conditions for a pickup appeared to be in place. In other advanced economies, including Korea, Singapore, and Hong Kong, growth in 1996 slowed from above-trend rates, reflecting a weakening in exports and, in some cases, a tightening of monetary conditions.

Chart 5.
Chart 5.

Major Industrial Countries: Output Gaps1

(Actual less potential, as a percent of potential)

Recently, greater differences have emerged in the relative cyclical positions of the major industrial countries.

1 Shaded areas indicate IMF staff projections. The gap estimates are subject to a significant margin of uncertainty. For a discussion of the approach to calculating potential output, see World Economic Outlook, October 1993, p. 101.2 Data through 1991 apply to west Germany only.

Growth in the advanced economies is expected to firm to almost 3 percent in 1997, a projection that has changed little from the October 1996 World Economic Outlook, and to remain at this rate in 1998 (Table 2). Although growth is expected to improve in 1997 in Europe, its projected pace of 2½ percent will be insufficient to make any significant dent in the high level of unemployment.

Table 2.

Advanced Economies: Real GDP, Consumer Prices, and Unemployment Rates

(Annual percent change and percent of labor force)

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The projections for unemployment have been adjusted to reflect the new survey techniques adopted by the U.S. Bureau of Labor Statistics in January 1994.

Consumer prices are based on the retail price index excluding mortgage interest.

Consumer prices excluding interest rate components; for Australia also excluding other volatile items.

Safeguarding price stability is critically important for ensuring continued economic expansion and requires careful monitoring of underlying price pressures. To illustrate the considerations involved, Table 3—introduced in the October 1996 World Economic Outlook, and updated to reflect recent changes—seeks to answer a number of questions about various signs of inflationary pressure in each of the major industrial countries. In general, policymakers’ credible commitment to reasonable price stability has played an important role in taming inflation and will remain essential to keeping inflation down. In the United States and the United Kingdom, where resource use is high, inflation remains subdued, although some recent evidence suggests a risk of price pressures in both countries. Relatively large output gaps arising from delayed or weak recoveries in Canada, France. Germany, Italy, and Japan indicate that there is little risk of a resurgence of inflation as growth firms in the year ahead.

Table 3.

Major Industrial Countries: Questions About Inflationary Pressures1

(Italics indicate a change since the October 1996 World Economic Outlook)

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This table is intended to provide a broad cross-country survey of inflationary pressures and reflects IMF staff judgments. For individual countries, various indicators will differ in the extent to which they contribute to the inflationary process.

Yield curve has steepened but this appears unlikely to reflect increased inflation expectations.

Rising Petroleum Prices in 1996

After remaining fairly steady at about $17 a barrel during most of 1994–95, the price of petroleum rose to about $21 a barrel by April 1996, subsequently receded, but climbed higher by year-end.1 Between 1995 and 1996, petroleum prices increased on average by about 20 percent. The spot price peaked in the second week of January 1997 at about $25 a barrel and declined by about $6 a barrel by the end of February reflecting the less severe winter weather—as compared with a year earlier—in Europe and North America, rising global oil production, particularly the resumption of oil export shipments by Iraq, and the strengthening of the U.S dollar.

The upward trend in petroleum prices in 1996 can be explained by the interaction between low inventories of crude oil and petroleum products and weather-related demand for heating oil. Inventories of crude petroleum and petroleum products are usually run down by the end of the Northern Hemisphere’s winter season, with replenishment beginning in May and June before the summer maintenance period in the North Sea and well in advance of the next winter season. However, following the relatively severe 1995/96 winter, early stock replenishment was more limited than usual, and there was little additional accumulation until late October. As a result, stocks were lower at the beginning of the 1996/97 winter season than at the beginning of the 1995/96 winter season.

The low level of stocks was partly attributable to the reluctance to accumulate sizable inventories given the continued expectation of lower prices in the not too distant future. During most of 1995 and throughout 1996, the prices for distant deliveries of crude oil were at substantial discount to prices for near deliveries, reflecting expectations of increased supplies, mainly from Iraq but also from other sources. In September 1996, for example, futures prices for West Texas crude for September 1997 delivery were about $3.50 a barrel (about 15 percent) below prices for December 1996 contracts (see chart). This price pattern created little incentive to increase private stocks above the levels required to meet immediate consumption demand. Thus, each time unexpected adverse weather increased demand for heating oil, there was little supply buffer, and prices rose sharply. The Organization of Petroleum Exporting Countries (OPEC) appears to have had little to do with the rise in petroleum prices in 1996 and early 1997. In fact, trade journals have reported that a number of countries have been producing in excess of their OPEC quotas, with Venezuela and Nigeria exceeding the quotas regularly and by substantial margins.2


West Texas Oil Prices: Spot and Futures Contracts1

(In U.S. dollars a barrel)

1 Spot prices arc monthly averages.

Agreement was reached in December between Iraq and the United Nations on the implementation of an oil-for-food sales plan, which allows Iraqi oil exports of up to $1 billion in each 90-day period. World oil production is expected to be stronger—through continued exports from Iraq, and higher exports from the North Sea and several other sources—which should restore inventories to more normal levels, thereby loosening the supply constraint that helped to drive prices upward in 1996. Prices quoted on futures markets indicate that average 1997 prices will be about 5 percent lower than average 1996 prices, and prices at the end of the year will be about 20 percent lower than at the end of 1996. In fact, nearly all of the correction in oil prices reflected in recent futures contracts seemed to have occurred by mid-February, earlier than had been anticipated by the markets.

1The average petroleum price referred to is the simple mean of prices for U.K. Brent, Dubai, and West Texas crude petroleum.2Crude oil production by OPEC members in the fourth quarter of 1996 is reported in trade journals to have been 26.3 million barrels a day (mbd) compared with 25.9 mbd in the third quarter. December crude oil production by these countries is estimated at 26.6 mbd, including 0.85 mbd in Iraq. These levels of production compare with the total OPEC quotas of 25.033 mbd, See, for example, International Energy Agency, Oil Marker Report, January 14, 1997.

Similarly, in a number of other advanced economies where signs of recovery have recently emerged, including Austria, Belgium, Finland, and Sweden, considerable slack can also be expected to dampen inflationary pressures. Moderating economic growth in 1996 in Australia and New Zealand has allayed earlier concerns about the possibility of overheating. The highest inflation rates in the advanced economies are in Greece, Hong Kong, and Israel, each of which is expected to see inflation of 7–8 percent over the next year. Overall, therefore, inflation remains subdued in most of the advanced economies and, taking into account recent and projected movements in primary commodity prices, including recent declines in petroleum prices, is expected to remain at about 2½ percent through 1998.

The overall growth and inflation projections mask considerable differences in the pace and phase of, and in the risks to, economic expansion among the advanced economies. Growth in 1997 is expected to edge somewhat above potential in the United States and the United Kingdom, two countries that are into their fifth or sixth year of economic expansion. Although inflation is expected to remain relatively subdued in both countries, the high level of resource use implies a growing risk of overheating.

In the United States, the economy continued to operate near capacity during 1996, with further improvements in business and consumer confidence. The unemployment rate fell to 5¼ percent in midyear and subsequently remained close to that level, below most estimates of the natural rate. Despite high resource use, the core rate of inflation has remained subdued at just above 2½ percent;3 there has, however, been some acceleration of wages. Following a 3 percent rate of expansion in 1997, growth is expected to moderate to about the rate of potential in 1998, and inflation to remain close to 3 percent. A pickup in inflation and the need for a stronger tightening of monetary policy than is assumed remain a risk to the forecast. The federal budget deficit declined to 1½ percent in fiscal year 1996, the lowest ratio to GDP since 1974, reflecting expenditure restraint as well as the strong cyclical position of the economy (Table 4). The Federal Reserve left the target federal funds rate unchanged at 5¼ percent between February 1996 and late March 1997, but then increased it by 25 basis points to restrain persistently strong demand and avert the risk of inflationary pressure. In late January 1997, for the first time, the U.S. Treasury issued inflation-indexed securities, auctioning just over $7 billion of such securities with a ten-year maturity, at a real yield of 3½ percent. The differential with respect to the yield on nonindexed bonds of comparable maturity provides a rough indication of the market’s inflation expectations over the medium term.4 At the time of the auction, this differential was about 3¼ percent.

Table 4.

Major Industrial Countries: General Government Fiscal Balances and Debt1

(In percent of GDP)

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Note: The budget projections are based on information available through March 1997. The specific assumptions for each country are set out in Box 2. See also notes to Chart 3.

The output gap is actual less potential output, as a percent of potential output. Structural balances arc expressed as a percent of potential output. The structural budget balance is the budgetary position that would be observed if the level of actual output coincided with potential output. Changes in the structural budget balance consequently include effects of temporary fiscal measures, the impact of fluctuations in interest rates and debt-service costs, and other noncyclical fluctuations in the budget balance. The computations of structural budget balances are based on IMF staff estimates of potential GDP and revenue and expenditure elasticities (see the October 1993 World Economic Outlook, Annex I). Net debt is defined as gross debt less financial assets, which include assets held by the social security insurance system. Estimates of the output gap and of the structural budget balance are subject to significant margins of uncertainty.

Data before 1990 refer to west Germany. For net debt, the first column refers to 1986–90. Beginning in 1995, the debt and debt-service obligations of the Treuhandanstalt (and of various other agencies) were taken over by the general government. This debt is equivalent to 8 percent of GDP and the associated debt service to ½ of 1 percent of GDP.

Figure for 1980–90 is average of 1983–90.

Data from 1996 onward reflect a new accounting methodology.

United States: Sources and Implications of Bias in the Consumer Price Index

Changes in the consumer price index (CPI) provide the most commonly used measure of inflation in all countries. In a recent study, the U.S. Advisory Commission to Study the Consumer Price Index estimated that the U.S. CPI overstated inflation by 1.1 percentage points in 1996, and by slightly more in each of the previous twenty years.1 Thus, whereas the official 1996 rate of inflation was 2.9 percent, the true rate of inflation may have been in the neighborhood of 1.8 percent. This upward bias arises because the CPI methodology does not adequately capture shifts in consumer purchases when relative prices move, or the effects of changes in quality, or the introduction of new products, or the increasing number of discount stores. White some experts have disputed that the upward bias is as large as suggested by the Commission, there is a growing consensus that there may be significant bias.

Upward bias in the official inflation rate has important implications. First, real wage growth may have been significantly higher over the past two decades than suggested by official data, which indicate that they have hardly grown at all.2 Second, in the area of fiscal policy, upward bias has considerable budgetary cost: expenditures indexed to the CPI rise more than needed to offset inflation; and tax brackets are overadjusted by the CPI, reducing tax revenues. Recent estimates indicate that if the current inflation bias continues for the next ten years, the federal government deficit will increase on this account alone by $140 billion by the end of the period, and more than $650 billion will be added to the U.S. national debt.

Sources of Bias in the U.S. Consumer Price Index, 1996

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The Commission’s report identified and quantified three sources of bias, all of which arise because of limitations in the methodology of how the CPI is calculated (see table).

(1) Quality change and new product bias, the largest source of bias, arises because the CPI does not adequately take into account improvements in the quality of goods and services and the introduction of new products. If changes in quality are not taken into account, changes in the CPI will not show true inflation, because they will partly reflect changes in the characteristics of products. New products need to be incorporated into the CPI on a timely basis so that the early declines in price that are a normal part of the product life cycle are captured.

(2) Substitution bias occurs because the CPI assumes that consumers purchase a constant mix (in terms of quantities) of various goods and services despite changes in relative prices. In actuality, if the price of one good rises relative to that of another good, consumers will tend to substitute away from the relatively higher priced good. Because the weights of goods in the CPI are adjusted infrequently (revisions occur about once every ten years), substitution is not taken into account, creating an upward bias.

(3) Outlet substitution bias occurs because the CPI does not adequately take into account the extent to which new discount-type stores have offered lower prices and enticed consumers away from the more traditional outlets that tend to be more fully represented in the CPI basket.

To eliminate the various biases, the Commission recommends replacing the method used in calculating the CPI with one that more accurately takes into account changing spending patterns.3 Other changes recommended include adopting new procedures for annual updates of weights and revisions to historical data; changing the price data and methods of collection; and establishing a committee of outside experts to review and advise on statistical issues.

The Commission’s conclusions have been subject to some criticism. There is widespread agreement among economists that an upward bias in the CPI exists, but its magnitude remains controversial. The largest uncertainties surround the magnitudes of quality and new product bias. Measuring quality improvements is particularly difficult because direct quantitative evidence is scarce and no new substantive information on this issue was provided in the report. Some critics have noted that the report does not take into account the fact that for some goods and services quality has deteriorated.

Although the debate about upward bias in the CPI has been most active in the United States, the findings of the Commission’s study are relevant more generally, as many countries use methodologies having much in common with that used in the United States. Analyses of the Canadian CPI suggest that there may be an upward bias in the range of ½–1 percentage point, somewhat lower than in the United States, reflecting in part the more frequent updating in Canada of the weights of the goods and services in the CPI market basket.4 A study on the United Kingdom’s retail price index (RPI) suggests a plausible range of bias of about 0.35–0.8 percentage point, although further work is under way to assess whether the bias may be larger.5 More generally, the magnitude of bias in other countries depends on, among other factors, the frequency with which the CPI weights and items sampled are updated; the extent to which new and improved products are brought to market; the formula used in estimation; and the extent to which quality adjustments are made. For example, countries such as Norway, Sweden, and the United Kingdom, where weights are updated annually, are likely to be less susceptible to substitution bias. Although most industrial countries—including the United States—make some attempt to allow for quality changes, they are not successful in eliminating this form of bias entirely. In most of the developing and transition countries, however, no quality adjustments are made, suggesting that this form of bias may be important, particularly when newly opened markets increase the variety and quality of goods and services available to the consumer.

1Toward a More Accurate Measure of the Cost of Living, Final Report to the Senate Finance Committee from the Advisory Commission to Study the Consumer Price Index, December 4, 1996. The report notes that the 1.1 percentage point estimate of bias falls within a plausible range of 0.8 to 1.6 percentage points.2Preliminary evidence suggests that the GDP deflator also suffers from upward bias implying mat real GDP growth and productivity may have been understated over the last two decades. The magnitude of this bias, however, remains to be fully documented.3This would entail switching from the currently used base-weighted price index to a chain-superlative formula. By taking into account both current and previous purchasing patterns, the latter method would substantially eliminate substitution bias.4See, for example, A. Crawford, “Measurement Bias in the Canadian CPI,” Technical Report No, 64 (Ottawa: Bank of Canada, 1993), This study suggests that the bias is not more than 0.5 percentage point.5Alastair Cunningham, “The Measurement Bias in Price Indices: An Application to the U.K.’s RPI,” Bank of England Working Paper No. 47 (March 1996).

Growth in the United Kingdom, having moderated during 1995, strengthened to rates close to or above potential during 1996 as private consumption rebounded. By early 1997, unemployment had fallen to 6¼ percent, one of the lowest rates in Europe, although in the current cyclical upswing unemployment has fallen significantly more than employment has risen, partly owing to changes in the unemployment benefit system. The rate of inflation remained above its 2½ percent target throughout 1996, rising above 3 percent temporarily in the final quarter. Increasing tightness in the labor market (reflected in an acceleration of labor earnings to 5 percent annual growth in early 1997), a significant pickup in house prices, and rapid monetary expansion may be viewed as early warning signals that inflationary pressures are building. The 1997 growth projection has been revised up to 3¼ percent, reflecting the renewed strength in private consumption, and an expected pickup in investment spending. The threat posed to the United Kingdom’s inflation target by the growing momentum in the economy prompted the authorities in October 1996 to raise the minimum lending rate by 25 basis points to 6 percent. The appreciation of sterling since August should also have a dampening effect on demand and price pressures. Fiscal slippages during 1995–96, accounted for mainly by revenue shortfalls, slowed the pace of fiscal consolidation, and the budget presented in November tightened fiscal policy only slightly further in the near term. Thus, during 1996 the planned path of deficit reduction toward medium-term balance was put back a year. The general government deficit for 1997 is projected to be close to 3 percent.

The pace of economic expansion in Australia moderated over the course of 1996 as consumption spending slowed. An improvement in the outlook for inflation provided room for the authorities to lower interest rates in the latter part of 1996, which should help sustain growth through 1997. In New Zealand, economic expansion slowed to about 2¾ percent in 1996, the slowest growth in four years but a welcome development as it reduced the risk of overheating. Economic activity is expected to strengthen in 1997 owing to a pickup in consumption, reflecting recent and planned future tax cuts.

In contrast to the countries that are in advanced stages of their current expansions, in Japan recovery did not get under way in earnest until late 1995. Since then growth has fluctuated, around a moderate underlying pace. Domestic demand growth has remained modest, with increases in business fixed investment largely offset by small declines in private consumption and the initial effects of an unwinding of the earlier surge in public investment. With the official discount rate at ½ of 1 percent since September 1995, monetary policy has been set so as to provide important stimulus to economic recovery (Chart 6). With fiscal policy also supporting economic activity, the general government deficit (excluding social security) reached 7¼ percent of GDP in 1996, of which 6¼ percentage points were structural. The structural deficit is expected to decline to about 4½ percent of GDP in 1997 as a result of further reductions in public investment expenditures, the unwinding of temporary cuts in income taxes, and a rise in the consumption tax, The recovery in labor earnings and rising net exports are expected to sustain growth, outweighing the effects of the withdrawal of fiscal stimulus. The 1997 growth projection for Japan has been revised down slightly to 2¼ percent partly to reflect the possible adverse effects of recent stock market weakness and lower confidence. The inflation rate is expected to rise slightly in 1997 albeit largely due to the increase in the consumption tax.

Chart 6.
Chart 6.

Three Major Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Yields1

(In percent a year)

Policy-related interest rates in Japan and Germany remain low.

1 The U.S. federal funds “target” rate, Japanese overnight call rate, German repurchase rate, and all ten-year government bond yields are monthly averages. All other series are end of month.

In Canada, following a reasonably strong upswing in 1993–94, the economy slowed considerably in 1995. A revival of activity emerged in the second half of 1996, but growth for the year amounted to only 1½ percent. Domestic demand, particularly increases in residential construction and investment in machinery and equipment, has fueled the recent pickup. Unemployment has remained in the 9½–10 percent range for most of the period since late 1994; and core inflation eased further to about 1½ percent last year, within the lower half of the official target range of 1 to 3 percent. In this context of low inflation, a large output gap, and upward pressure on the Canadian dollar, the Bank of Canada lowered short-term interest rates by close to 3 percentage points during 1996, thereby maintaining an accommodative monetary policy stance. This easing of monetary conditions, the return of confidence, and continued progress in reducing the fiscal deficit helped lower long-term interest rates. The strength of fundamentals in Canada bodes well for continuing recovery in 1997–98, with inflation remaining within the target range.

In contrast with the sustained growth in countries such as the United States and the United Kingdom, the continuing moderate upturn in Japan, and the promising recovery in Canada, growth in continental Europe has been more modest and prospects remain uncertain. Nevertheless, a number of improvements that have occurred in the economic environment are expected to contribute to a strengthening of activity in 1997. The mix of economic policies has shifted since 1995 in a direction that is more conducive to sustainable growth in the medium term. A high degree of price stability and continued efforts at fiscal consolidation have allowed a more accommodative stance of monetary policy, and monetary conditions, broadly defined to include the effects of exchange rate changes, have eased considerably since early 1995, particularly in France (Chart 7). Short-term interest rates in Germany were cut by 75 basis points during 1996, following larger reductions in each of the three preceding years, and a number of other European countries lowered their rates in tandem. Commitment to fiscal consolidation has also contributed to declines in long-term interest rates, and exchange rates vis-à-vis key non-ERM currencies have returned to more competitive levels from their positions of early 1995, providing stimulus to net exports and the opportunity to take advantage of solid world demand.

Chart 7.
Chart 7.

Major Industrial Countries: Monetary Conditions Indices1

An easing of monetary conditions—broadly defined to lake account of changes in both interest rates and exchange rates—in Germany and France is expected to support a resumption of growth.

1 For each country, the index is defined as a weighted average of the percentage point change in the real short-term interest rate and the percentage change in the real effective exchange rate from a base period (January 1990). Relative weights of 3 to 1 are used for Canada, France, Italy, and the United Kingdom, 4 to 1 for Germany, and 10 to 1 for Japan and the United States. The weights are intended to represent the relative impacts of interest rates and exchange rates on aggregate demand; they should be regarded as indicative rather than precise estimates. For instance, a 3-to-1 ratio indicates that a 1 percentage point change in the real short-term interest rate has about the same effect on aggregate demand over time as a 3 percent change in the real effective exchange rate. Movements in the index are thus equivalent to percentage point changes in the real interest rates. The lag with which a change in the index may be expected to affect aggregate demand depends on the extent to which the change stems from a change in the interest rate or the exchange rate, and varies depending on the cyclical position; the lag also differs across countries. No meaning is to be attached to the absolute value of the index; rather, the index is intended to show the degree of tightening or easing in monetary conditions from the (arbitrarily chosen) base period. Small changes in the relative weights may affect the value of the index but not the qualitative picture.

With this favorable climate, there would seem to be some upside potential to the 1997 European growth projection of 2½ percent, but this conjecture is balanced by a number of considerations working in the opposite direction. A convincing revival of domestic demand remains to be seen particularly in Germany, France, and Italy (Chart 8). Record levels of unemployment have eroded consumer confidence and weakened consumer spending (Chart 9). Large margins of slack may mean that sluggishness in business investment will continue for some time to come. Moreover, further efforts to achieve fiscal consolidation and meet the 3 percent Maastricht reference value for budget deficits are likely to have a dampening effect on domestic demand (Table 5).5 At the same time, however, failure to reach the deficit target could heighten uncertainty about EMU and further undermine business and consumer confidence. In addition to macroeconomic factors, structural rigidities in European labor markets have also been contributing to the lack of dynamism, creating a vicious circle of prolonged underutilization of resources, erosion of human capital, and rising levels of already high structural unemployment. Structural unemployment, which will not decline through economic recovery alone, probably accounts for close to three-quarters of the 11¼ percent unemployment rate in Europe.

Chart 8.
Chart 8.

Selected European Countries: Real Total Domestic Demand

(Percent change from four quarters earlier)

A convincing revival of domestic demand remains to be seen in continental Europe.

Chart 9.
Chart 9.

European Union and the United States: Indicators of Consumer Confidence1

Consumer confidence remains particularly weak in the countries of the European Union.

Sources: For the United States, the Conference Board; and the European Commission.1 Indicators are not comparable across countries.2 Percent of respondents expecting an improvement in their situation minus percent expecting a deterioration.
Table 5.

European Union: Convergence Indicators for 1995, 1996, and 1997

(In percent)

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Sources: National sources; and IMF staff projections.Note: The table shows the convergence indicators mentioned in the Maastricht Treaty, except for the exchange rate. The three relevant convergence criteria are (1) consumer price inflation must not exceed that of the three test-performing countries by more than 1½ percentage points; (2) interest rates on long-term government securities must not be more than 2 percentage points higher than those in the same three member slates; and (3) the financial position must be sustainable. In particular, the general government deficit should be at or below the reference value of 3 percent of GDP. If not, it should have declined substantially and continuously and reached a level close to the reference value, or the excess over the reference value should be temporary and exceptional. The gross debt of general government should be at or below 60 percent of GDP or, if not, the debt ratio should be sufficiently diminishing and approaching the 60 percent value at a satisfactory pace. The exchange rate criterion is that the currency must have been held within the normal fluctuation margins of the ERM for two years without a realignment at the initiative of the member state in question.

Based on information available up to the end of March 1997.

Official targets or intentions. The IMF staff’s fiscal projections shown in the preceding column are in some cases based on different growth, inflation, or interest rate assumptions from those used by national authorities and do not take into account further consolidation measures that are planned by EU governments in accordance with their convergence programs but which have not yet been announced. See Box 2 for the IMF staff’s fiscal assumptions.

Debt data refer to end of year. They relate to general government but may not be consistent with the definition agreed at Maastricht.

Ten-year government bond yield or nearest maturity.

While some other EU countries have adopted supplementary fiscal actions for 1997 (e.g., France and Italy), the German authorities have not yet announced additional measures to achieve the Maastricht fiscal deficit criterion.

Retail price index excluding mortgage interest.

Government deposits with the central bank, government holdings of nongovernment bonds, and government debt related to public enterprises amounted to some 20 percent of GDP in 1995.

Long-term interest rate is 12-month treasury bill rate.

Average weighted by GDP shares, based on the purchasing power parity (PPP) valuation of country GDPs for consumer price index, general government balances, and debt.

The Treaty is not specific as to what methodology should be used to calculate reference values for inflation and the interest rate beyond noting that they should be based on the three lowest-inflation countries. For illustrative purposes, a simple average for the three countries is used in calculating the reference values.

Indicators of economic activity in Germany remain mixed. Real GDP rebounded quite strongly in the second and third quarters of 1996 but growth slowed to a virtual halt in the fourth quarter. The export sector has been the main source of strength, and business confidence has rebounded; but domestic demand growth has remained modest, consumer confidence has yet to recover, and unemployment rose to a new seasonally adjusted peak of 11¼ percent in January before falling slightly in February. Inflation remains subdued, at about 1½ percent, with wage settlements in 1996 generally below 2 percent, and settlements thus far in 1997 of about 1 percent.

In contrast with the easing of monetary conditions referred to above, the stance of fiscal policy in Germany is being tightened in 1997, correcting the slippages that occurred in 1995 and making up for the lack of progress in 1996. From a general government deficit of about 4 percent of GDP in 1996, the fiscal program for 1997 aims to reduce the budget deficit to below 3 percent of GDP to meet the Maastricht criteria, although fully achieving this objective may be difficult without additional policy action. With monetary conditions supportive of moderate recovery, growth of 2¼ percent is projected for 1997, with continuing strong expansion of exports helping to revive investment in machinery and equipment. Consumption is expected to pick up later in the year. Reflecting the considerable output gap, inflation is projected to remain subdued. Weaker-than-expected investment and consumption could, however, delay prospects for recovery.

In France, economic activity in 1996 as a whole remained sluggish, with real GDP increasing by about 1¼ percent. Despite weak income growth and very low consumer confidence, consumer spending as well as net exports contributed positively to growth. Investment, however, remained flat, and destocking continued to be a drag on growth. Unemployment reached a new peak of 12¾ percent in early 1997. Inflation remained firmly under control. The fiscal deficit was held to the government’s 1996 target of 4 percent of GDP, following the adoption of a supplementary budget in November. Fiscal plans for 1997 entail keeping central government spending unchanged in nominal terms and strict limits on social security expenditure; but additional measures appear necessary to bring the deficit below 3 percent of GDP on a durable basis, Since the Deutsche Bundesbank last lowered short-term interest rates in August, the Bank of France has reduced its operating rates by between 15 and 25 basis points; while the franc has remained stable against the deutsche mark, it has depreciated against the dollar and in effective terms.

Growth in 1997 is expected to strengthen to almost 2½ percent, as the underlying expansion of private consumption is maintained and exports continue to expand. Unemployment is expected to exceed 13 percent by midyear, and inflationary pressures are likely to remain negligible. Though growth could be stronger if exchange rates remain near their levels in early 1997, there is at least an equal risk that rising unemployment could undermine consumption and that sluggishness in European growth could hinder the expansion of exports.

In Italy, activity stagnated in 1996, reflecting in part the strengthening of the lira since mid-1995 and the weakness of key export markets in Europe. Industrial production declined during the year, and unemployment was relatively stable at about 12 percent. Inflation has been the main bright spot of recent performance, falling from 6 percent in November 1995 (on a 12-month basis) to 2¼ percent in March 1997. Modest growth of 1 percent is expected in 1997. Apart from the direct effects of fiscal tightening, growth remains dampened by the lagged effects of the lira’s appreciation and depressed private sector demand. Inflation is expected to remain subdued and in line with the official target for the year of 2½ percent.

The substantial headway made in reducing Italy’s fiscal imbalances in 1992–95 stalled in 1996, owing to inadequate expenditure control as well as weak growth. Despite the corrective measures taken at midyear, the general government deficit, at 6¾ percent of GDP (inclusive of all accounting revisions), exceeded the official target by a considerable margin. For 1997, the government’s objective of early EMU participation will require a comparatively large fiscal correction, for which additional measures were recently taken, along with the announcement of a forthcoming review of pension and welfare spending. The additional package should serve to reduce the deficit to close to the Maastricht reference value in 1997. However, the considerable reliance in 1997 on one-off measures would—in the absence of additional measures—lead to a rebound of the deficit in subsequent years. Hence it is important that the forthcoming review of social transfers leads to structural cost-saving measures to ensure the sustainability of adjustment in 1998 and the medium term. Increased market confidence in the authorities’ commitment to reduce the budget deficit and bring down inflation has contributed to a marked reduction in long-term interest rates over the past two years. The performance of the lira in the ERM, which it rejoined in November 1996, and continued subdued inflation allowed a reduction of 75 basis points in official interest rates in late January 1997, following a similar reduction in October 1996.

Evidence of economic recovery is apparent in a number of the smaller economies of Europe. In Sweden, economic activity picked up around the middle of last year, primarily fueled by the external sector and investment spending. Monetary policy was eased significantly during 1996 with cuts in the repurchase rate. Growth is expected to strengthen further in 1997. A pickup in exports has also contributed to tentative recoveries in Austria, Finland, and Spain. In Austria, the external sector and business fixed investment are expected to support stronger growth during 1997 and 1998. Further fiscal consolidation, however, aimed at reducing the fiscal deficit by about 1 percent of GDP in 1997 may keep economic activity somewhat subdued. In Finland the strengthening of exports during 1996 has contributed to a resumption of growth. Continued buoyancy of consumption and investment is also supporting growth, which is expected to exceed 4 percent in 1997. In Spain, exports and equipment investment are the driving forces behind the emerging recovery. Employment growth has been stronger than in previous economic cycles, but unemployment of over 22 percent remains Spain’s greatest economic challenge.

Elsewhere in continental Europe, revivals of domestic demand are contributing to recoveries from the 1995 slowdown. Activity strengthened in early 1996 in Denmark, with notable increases in construction and in private consumption, and also in the Netherlands, reflecting gains in employment and more buoyant consumer spending. Growth of exports coupled with continued buoyancy in domestic demand is expected to sustain relatively solid growth in both countries in the year ahead. In Portugal also, growth picked up in 1996 as both consumption and investment improved. Activity is expected to firm over the next year as investment strengthens further. Similarly in Belgium, a recovery in business fixed investment is expected to support stronger growth. In Greece, despite consolidation plans to reduce the structural fiscal deficit substantially in 1997, economic growth is expected to pick up, led by investment. In contrast, domestic demand in Switzerland remains weak, and real GDP in 1996 contracted by ¾ of 1 percent. With monetary policy now having been eased substantially, real GDP is projected to expand, but by less than 1 percent in 1997, supported mainly by the partial reversal of the earlier excessive appreciation of the Swiss franc.

Robust economic recoveries in Ireland, Norway, and Israel have slowed, or are expected to slow, to a more sustainable pace. Growth in Ireland moderated to 7 percent in 1996 after peaking at over 10 percent in 1995, and inflation has also decelerated. The strong and broadly based economic upswing in Norway continued, with real GDP accelerating to 5 percent growth in 1996. Although the expansion is expected to moderate somewhat in 1997, the marked tightening of the labor market in the current upswing and the recent easing of monetary policy, motivated by exchange rate considerations, indicate a risk of rising inflation. In Israel, six years of rapid economic growth with widening budget deficits culminated in a sharp increase in the current account deficit during 1995–96, with inflation near 10 percent. The projected tightening of fiscal policy, if successfully implemented, should allow growth to continue at a more sustainable pace, the external imbalance to narrow, and inflation to moderate.

In several of the advanced economies of Asia, growth slowed during 1996, and growth projections for 1997 have been revised downward somewhat. The slowdown, which represented a mild cyclical correction following the above-trend growth rates of 1994–95, resulted partly from appropriate policy tightening intended to diminish the risk of overheating. At the same time, exports slowed owing to losses in the external competitiveness of currencies tied to the appreciating U.S. dollar, weaker import demand from other advanced economies and from within the region, and the general deceleration in world industrial activity, which was particularly pronounced in the global electronics market. The slowdown in the growth of export revenues in U.S. dollar terms was particularly marked, reflecting the appreciation of the U.S. dollar; in SDR terms, the slowing of export revenues was less pronounced (Chart 10). A recovery in exports is expected in 1997, as global demand firms. In Hong Kong, growth in private consumption and continuing rapid growth in China are expected to support somewhat stronger growth in 1997. In Singapore, improvements in the external sector are expected to offset a moderation in both public consumption and private investment—which made considerable contributions to GDP growth last year—resulting in growth of about 6½ percent in the year ahead. In Taiwan Province of China, a recovery in domestic demand should support activity in 1997. In Korea, the slowdown in growth to 7 percent has reduced the risk of overheating, The short-term outlook for growth appears favorable, although labor unrest and uncertainties associated with the recent Hanbo bankruptcy imply some downside risk.

Chart 10.
Chart 10.

Selected Asian Countries: Growth in Export Revenues1

(Percent change from 12 months earlier: three-month moving averages)

Exports in U.S. dollar terms from a number of Asian countries slowed markedly during 1995–96; in a number of countries, the slowdown was less pronounced in SDR terms.

1 Trade in goods and services.

Economic Situation and Prospects in Developing Countries

In the developing countries, growth in output firmed to 6½ percent in 1996, marking the fifth consecutive year of expansion of around 6 percent, and the median inflation rate slowed to about 7 percent, the lowest rate in nearly a quarter century (Table 6). Sustained growth close to 6½ percent, with further declines in inflation, is expected in the period ahead.

Table 6.

Selected Developing Countries: Real GDP and Consumer Prices

(Annual percent change)

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African countries that had arrangements, as of the end of 1996, under the IMF’s Structural Adjustment Facility (SAF) or Enhanced Structural Adjustment Facility (ESAF).

“onsumer prices” are based on a price index of domestic demand, which is a weighted average of the consumer price index, the wholesale price index, and a price index for construction activity. The average year-on-year increase in 1995 in this price index was 59.6 percent, which largely was the result of carryover effects from the high inflation rate prevailing prior to the introduction of the real on July 1, 1994. Consequently, the inflation rate from December 1994 to December 1995, which was 14.8 percent, better reflects the underlying rate during 1995. From December 1995 to December 1996, the inflation rate was 9.3 percent.

Among the developing countries of the Western Hemisphere, growth picked up to 3½ percent in 1996—a somewhat better performance than projected last October—and inflation declined further. Growth in the region is expected to reach almost 4½ percent in 1997 as recoveries in several countries gain momentum, and inflation is projected to moderate further. In Mexico, the economic recovery in 1996 exceeded most expectations, with real GDP increasing by 5 percent. Strong export performance and a pickup in domestic investment—reflecting improved confidence and lower interest rates—are expected to sustain recovery this year. Tight fiscal and monetary policies should help to lower inflation to below 20 percent. Economic recovery also gathered strength in Argentina, with GDP increasing by about 4½ percent in 1996 after a comparable decline in output in the preceding year; inflation was virtually zero. With a pickup in growth in the second half of the year, Brazil’s economy expanded by 3 percent in 1996, and inflation declined to about 11 percent, its lowest rate in many years. Reflecting the success of the real plan, a further strengthening of growth and decline in inflation are expected in the year ahead. In Chile, high real interest rates and weaker exports associated with the fall in world copper prices reduced growth to 7 percent in 1996, and a further slowdown is projected for the year ahead. Nevertheless, Chile’s growth rate in 1997, at about 5¾ percent, will again be one of the highest in the region. Although the adjustment measures taken in early 1996 in Venezuela contributed to a 1 percent decline in output, they succeeded in improving financial stability: the exchange rate stabilized, and inflation began to decline in the second half of the year Economic activity is expected to rebound this year, supported by higher oil prices and buoyant foreign direct investment in the newly privatized oil and mining sectors.

With an increasing number of countries in Africa making significant progress with macroeconomic stabilization and structural reform efforts, the upturn in economic growth that began in 1994–95 broadened further in 1996. In fact, the 5 percent expansion seen in 1996 was Africa’s best growth performance in two decades, and reflected strong activity in the primary products sector—agriculture, in particular, with a number of countries recovering from earlier adverse weather—and in some cases, manufacturing. Growth is expected to average about 4¾ percent in 1997. In South Africa, the government’s commitment to fiscal responsibility and structural reform is gaining increasing credibility, but efforts to stabilize the economy and remaining uncertainties are likely to constrain the pace of growth in the near term. In Morocco, the rate of expansion is expected to slow, mainly because of weaker performance in the agricultural sector. In many other countries in Africa, however, growth prospects are quite encouraging, with further declines expected in inflation. Adjustment efforts in Kenya have continued in many areas, including fiscal consolidation, but a weakening of growth is likely in 1997 reflecting the impact of a drought and a slowing of structural reform. Robust growth in Uganda continues to be fueled partly by capital inflows, and by investment in manufacturing and construction, all of which reflect increased confidence. In Ethiopia, growth surged to almost 8 percent in 1996, owing to strong performance of the agricultural sector, and inflation declined to about 1 percent. Tight monetary policy and further strong output growth should keep inflation at a similar level in 1997. Rapid growth driven by agricultural production and exports continued in Malawi during 1996, while inflation declined substantially. After the 1995 drought, output growth picked up in Zambia, largely owing to recoveries in agricultural and copper production, and is projected to strengthen further in 1997. Some limited progress was made during 1996 to restore economic stability in Nigeria, but inflation, while easing, remained high. A recovery in output and a further fall in inflation are expected in 1997.

Following the 1994 devaluation of the CFA franc and the implementation of associated structural adjustment programs, growth in the countries of the CFA franc zone registered a turnaround in 1995. During 1996, economic activity gathered strength, resulting in growth rates of about 5 percent. Output growth is projected to remain relatively strong in 1997, and inflation to remain low or to decline furthe. In Senegal, the rebound in agricultural production and continued expansion in the output of the industrial and construction sectors contributed to growth of 5 percent in 1996. In Cote d’lvoire, robust growth in 1996 was largely driven by expansion of exports, especially cocoa and petroleum, which partly reflected improved competitiveness. Inflation continued to abate despite further price liberalization measures.

Among the developing countries of Asia, growth in 1996 moderated to 8¼ percent. This aggregate outcome, however, masks diverse developments across the region. The weakening of export growth, noted earlier in the context of the advanced Asian economies, was also visible in a number of the fast-growing developing countries of the region. In some countries, such as Indonesia, Malaysia, and Thailand, the impact of the export slowdown on output coincided with the effects of tighter domestic financial policies aimed at reducing the risk of overheating. The decline in export growth affected activity in Thailand more than in other East Asian countries, although real GDP still grew by nearly 7 percent in 1996, with the current account deficit remaining large. In contrast, in Indonesia, the export slowdown was limited and partially offset by continued buoyancy of domestic demand, in part reflecting large capital inflows. As a consequence, growth remained close to 8 percent. In Malaysia, slower export growth, combined with a tighter monetary policy, helped contain overheating pressures. While labor markets in Malaysia are tight and rates of expansion in private credit, real estate sales, and investment demand have remained high, pressures on capacity should be eased by the tightening of fiscal policy announced in the 1997 budget. The economic recovery that began in 1994 continued in the Philippines, with a further strengthening of output. Deregulation and liberalization arc helping by producing supply-side benefits and growth is projected to strengthen slightly further in 1997 as investment and exports pick up.

In China, after three years of double-digit inflation, a soft landing was successfully achieved in 1996. While inflation declined to 6 percent, GDP growth was well maintained at about 9½ percent. The outlook for 1997 remains favorable, with growth roughly unchanged and inflation remaining in the single digits. In India, strong agricultural output partly offset a slowdown in the industrial sector so that real GDP growth slowed only moderately to about 7 percent in 1996, while inflation declined to 7 percent. In Pakistan, after economic activity started to pick up in early 1996, the fiscal position worsened and a balance of payments crisis ensued later in the year as the trade deficit widened and capital inflows slowed. The adjustment required is expected to lead to slower growth in 1997 but will help improve the medium-term outlook.

Solid performance continues in the Asian developing countries undergoing transition from central planning to market-based systems. Cautious fiscal and monetary policies in Vietnam succeeded in lowering inflation in 1996, while solid growth was maintained. Continued robust growth is expected in the year ahead, with only a slight increase in inflation. The economic recovery under way in Cambodia continued in 1996, although growth slowed somewhat reflecting the adverse impact of recent floods on rice output, and further progress was made in reducing inflation. In the Lao People’s Democratic Republic, growth remained buoyant owing to strong construction and services activity, which offset a slump in export-based manufacturing.

For almost a decade, the performance of many economies in the Middle East and Europe region has been disappointing. While the region has been periodically beset by political tensions and fluctuating oil revenues, inadequate economic policies also help explain the weak economic conditions. In recent years, however, a number of countries have implemented reform programs, albeit with varying degrees of commitment and subsequent success. Reflecting the continued progress toward macroeconomic stabilization and deregulation of the economy in the past few years, growth in Egypt increased to about 4 percent in 1996 and inflation was contained at about 7 percent. Prudent monetary and fiscal policies in Jordan have been supporting robust growth, which is expected to continue in the year ahead. Gradual fiscal consolidation has been the centerpiece of Saudi Arabia’s reform efforts during the past decade. Improved fiscal and external positions, buoyed by higher oil export revenues, contributed to increased private sector confidence and a pickup in economic activity in 1996. In contrast, overheating pressures continued in Turkey last year. Inflation accelerated to around 80 percent, the fiscal deficit climbed to over 9 percent of GDP, and interest rates reached over 120 percent.

Developments and Prospects in Transition Countries

For the countries in transition, considered as a group, the contraction in economic activity seems to have bottomed out in 1996 after six years of deep decline. Also last year, inflation fell to 40 percent on an annual average basis, its lowest rate since the transition began, and to lower levels on a 12-month basis by the end of the year (Table 7 and Chart 11). Output is expected to expand by 3 percent in 1997—with all but five countries registering growth of 2 percent or higher—and inflation to slow further. It should be emphasized that output data for these countries may underestimate actual growth because they may not take full account of various forms of economic activity, particularly the output of new enterprises and activity in the informal service sector (Box 5).

Chart 11.
Chart 11.

Selected Transition Countries: Inflation

In countries more advanced in transition, inflation has come down steadily. In those less advanced in transition, inflation has been reduced in the countries that have maintained tight financial policies.

Table 7.

Countries in Transition: Real GDP and Consumer Prices

(Annual percent change)

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Average annual percent changes in consumer prices can differ significantly from during-the-year changes. See Chart 11 for monthly data for selected countries in transition.