CHAPTER I PROSPECTS AND POLICY CHALLENGES
Author: International Monetary Fund. Research Dept.
Language:
English
Keywords:
WEO; exchange rate; financial market; U.S. dollar; emerging market; firm; price; country; flight to quality; headline inflation; consumer confidence; economic growth; consumer spending; Inflation; Oil prices; Consumer prices; Private investment; Emerging and frontier financial markets; Sub-Saharan Africa
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Abstract

Since the May 2001 World Economic Outlook, prospects for 2001–02 have weakened further, and downside risks have been further exacerbated by the recent terrorist attack in the United States (see Box 1.1). Growth projections for almost all regions have been reduced, reflecting a variety of factors, including the greater-than-expected impact of the global slowdown in a number of regions; a delayed recovery in the United States; weakening domestic demand growth and confidence in Europe; the prospect of a period of slower growth in Japan as it presses ahead with structural reforms (although this will have substantial medium-term benefits); the continued decline in information technology spending, which affects Asia in particular; and deteriorating financing conditions for emerging markets, especially in Latin America. GDP growth is now slowing in almost all regions of the globe, accompanied by a sharp decline in trade growth. In response, many countries—especially the United States—have eased macroeconomic policies, most recently in mid-September in the aftermath of the terrorist attack. This easing, along with the gradual abatement of oil prices and of other shocks that have contributed to the slowdown, should help support activity and confidence in the period ahead. But substantial uncertainties and risks persist, as the downturn makes the world more vulnerable to further unexpected developments, and a significant danger of a deeper and more prolonged slowdown remains. The recent terrorist attack has also increased uncertainty. The challenge facing policymakers is how best to limit these downside risks while promoting an orderly resolution of the imbalances in the global economy over the medium term.

Since the May 2001 World Economic Outlook, prospects for 2001–02 have weakened further, and downside risks have been further exacerbated by the recent terrorist attack in the United States (see Box 1.1). Growth projections for almost all regions have been reduced, reflecting a variety of factors, including the greater-than-expected impact of the global slowdown in a number of regions; a delayed recovery in the United States; weakening domestic demand growth and confidence in Europe; the prospect of a period of slower growth in Japan as it presses ahead with structural reforms (although this will have substantial medium-term benefits); the continued decline in information technology spending, which affects Asia in particular; and deteriorating financing conditions for emerging markets, especially in Latin America. GDP growth is now slowing in almost all regions of the globe, accompanied by a sharp decline in trade growth. In response, many countries—especially the United States—have eased macroeconomic policies, most recently in mid-September in the aftermath of the terrorist attack. This easing, along with the gradual abatement of oil prices and of other shocks that have contributed to the slowdown, should help support activity and confidence in the period ahead. But substantial uncertainties and risks persist, as the downturn makes the world more vulnerable to further unexpected developments, and a significant danger of a deeper and more prolonged slowdown remains. The recent terrorist attack has also increased uncertainty. The challenge facing policymakers is how best to limit these downside risks while promoting an orderly resolution of the imbalances in the global economy over the medium term.

Global growth is now projected at 2.6 percent in 2001,1 0.6 percentage points lower than expected in the May 2001 World Economic Outlook, and a decline of over 2 percentage points from the unusually rapid pace in 2000 (Table 1.1 and Figure 1.1). Among the advanced economies, growth in the United States is projected at 1.3 percent, 0.2 percentage points lower than in the May 2001 World Economic Outlook, with activity expected to begin to pick up modestly in the period ahead as the effects of previous policy easing take hold. The outlook for other industrial countries has weakened more significantly. In the euro area, growth has been marked down by 0.6 percentage points to 1.8 percent, driven by a sharp weakening in domestic demand growth, particularly in Germany, and the greater-than-expected impact of the global slowdown. Of most concern, the prospects for Japan have become increasingly somber. With GDP now projected to decline by 0.5 percent in 2001, over 1 percentage point worse than earlier projected, Japan is now likely experiencing its fourth recession of the past decade.2

Table 1.1.

Overview of the World Economic Outlook Projections

(Annual percent change unless otherwise noted)

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Note: (a) These projections were finalized before the September 11 terrorist attack in the United States and subsequent economic policy actions; (b) real effective exchange rates are assumed to remain constant at the levels prevailing during July 23-August 17, 2001.

Using updated purchasing-power-parity (PPP) weights, summarized in the Statistical Appendix, Table A.

Includes Indonesia, Malaysia, the Philippines, and Thailand.

Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $28.21 in 2000, the assumed price is $26.80 in 2001, and $24.50 in 2002.

Figure 1.1.
Figure 1.1.

Global Indicators1

(Annual percent change unless otherwise noted)

Global growth is projected to slow markedly in 2001, while inflation remains subdued.

1Shaded areas indicate IMF staff projections. Aggregates are computed on the basis of purchasing-power-parity weights unless otherwise indicated.2Average growth rates for individual countries, aggregated using purchasing-power-parity weights; these shift over time in favor of faster growing countries, giving the line an upward trend.3GDP-weighted average of the 10-year (or nearest maturity) government bond yields less inflation rates for the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada. Excluding Italy prior to 1972.

Prospects for most developing and transition countries have also deteriorated. Growth has been marked down sharply in the Western Hemisphere, where activity has been adversely affected by the renewed financial difficulties in Argentina, as well as political uncertainties and other shocks, including the energy crisis in Brazil. Capital inflows to most countries—except Mexico—have also slowed, a concern given the region’s large external financing requirement. In emerging Asia, growth in China remains resilient, but many countries have been hard hit by slowing global growth and the downturn in the electronics cycle, with the impact exacerbated by intraregional trade linkages and developments in Japan. Growth prospects have also weakened moderately in the Middle East owing to lower oil prices and cuts in production and the ongoing crisis in Turkey. Projected growth in Africa has also been reduced, although it is still expected to be higher than in 2000, aided by improved weather and an easing of security problems in several countries. In contrast, the outlook for the transition economies has remained broadly unchanged, with the impact of slowing growth in Europe offset by stronger-than-expected rebounds in a number of countries in the Commonwealth of Independent States, notably Ukraine.

This forecast has not been adjusted for the September 11 terrorist attack on the United States. Clearly, recent events will have an impact on activity in the short term, and add to the already significant downside risks both in the United States and elsewhere. The attack has taken a terrible toll in human lives and resulted in substantial property damage, but its direct impact on U.S. activity is likely to be moderate (as was the case, for example, with the Kobe earthquake in Japan on January 11, 1995, where the damage was, if anything, somewhat larger); moreover, indications are that the financial infrastructure around the world has held up well. However, the indirect effects may be more substantial, including the possibility of a sustained deterioration in consumer, corporate, and financial confidence, of a flight to quality in financial markets that could exacerbate existing weaknesses associated with financial stability or funding, and of oil price volatility. While it is as yet too early to make a full assessment of such risks, the recent cuts in interest rates in the United States, Canada, and Europe, accompanied by moderate additional easing in Japan, will be helpful in sustaining confidence and activity.

The Terrorist Attack: Impact on the Global Outlook

The latest round of quantitative projections presented in this World Economic Outlook were completed just before the tragic events of September 11. A central question is how these projections might be interpreted in light of the terrorist attack and its aftermath. At press time, there was no doubt that the attack was having a negative effect on activity in many regions of the globe, and that it had increased what were already significant downside risks to the short-term global outlook, including for emerging market economies. However, it is important to put the current economic situation in perspective. While there are clearly substantial uncertainties about unfolding events, one should not overlook that the economic fundamentals in many countries and in many respects have improved in recent years and, from an economic perspective, this leaves the world somewhat less vulnerable than it might otherwise be. These improvements, together with the aggressive response by central banks across the globe, should help reduce the risk of sustained reductions in consumer and business confidence, a key concern in the months ahead.

The attack has certainly had a substantial initial impact in financial markets, although experience suggests that financial markets can over-react to such shocks initially. In the two weeks following the attack, major stock market indices in the United States, Europe, and Japan have fallen by 5 to 15 percent. Many emerging stock markets have fared even worse, particularly in Latin America and East Asia. There has also been a broad-based flight to quality, reflected in a sharp rise in spreads for both high-yield and emerging-market bonds. Oil prices, after rising immediately after the attack, have since fallen back sharply to levels significantly below those prevailing on September 10. Movements in the major currencies have been relatively moderate, with the U.S. dollar weakening slightly against the euro and the yen.

National regulators, financial authorities, and market participants have shown that the global financial system can continue to function smoothly even under a difficult and totally unanticipated form of extreme duress. Monetary policy in the major economies has responded aggressively to support the global payments system and to strengthen confidence and activity. The monetary authorities in the United States, the euro area, Japan, Switzerland, Canada, and the United Kingdom directly injected large amounts of liquidity. The Federal Reserve also entered into temporary swap arrangements with the European Central Bank (ECB), the Bank of England, and the Bank of Canada to facilitate the functioning of financial markets and to provide liquidity in U.S. dollars. In addition, the Federal Reserve moved to cut interest rates by 50 basis points on September 17, quickly followed by cuts of the same magnitude by the Bank of Canada, and then the ECB and the Swiss National Bank. Subsequently, the Bank of England and the Bank of Japan also cut rates, as did the monetary authorities in a number of other economies, including Denmark, Sweden, New Zealand, Hong Kong SAR, and Korea. In the United States, additional fiscal appropriations for defense, reconstruction, and the airlines will also provide support to activity.

Abstracting from uncertainties surrounding the possibility of further conflict, what is the likely direct economic impact of the events of September 11? The attack has taken a terrible toll in human lives, but the direct economic damage—in relation to the overall United States economy—is still relatively moderate, even though certain industries have been hard hit, particularly airlines, insurance, and tourism. While it is difficult to find close parallels in recent history, the direct damage is much smaller than that resulting from the Kobe earthquake of January 1995, which, as it turned out, had only a very limited impact on output growth in Japan (Box 1.3). The potential indirect effects of the attacks—on consumer sentiment and spending, on business confidence, and on risk aversion—are likely to be significantly more important. These are much more difficult to assess, and will depend importantly on how non-economic events evolve in the aftermath of the attack.

On the economic front, there are a number of reasons for cautious optimism. First, there is now a sizable amount of policy stimulus in the pipeline in most major economies, even more than had been anticipated before the attack. Second, economic fundamentals across the globe are considerably stronger than they were a few years ago, reflected in lower inflation; stronger fiscal positions; greater monetary policy credibility; and, in many emerging markets, more flexible exchange rate regimes and lower external vulnerabilities. And third, the terrorist attack should not substantially affect underlying productivity growth in the U.S. economy and elsewhere, on which economic prosperity ultimately depends (see Chapter III).

At press time, the situation was fluid, making it premature to try to quantify the implications of the attack for growth in the United States and elsewhere. There will clearly be a short-term effect on activity, particularly in the last part of this year, both in the United States and in other countries. However, there is still a reasonable prospect that a recovery will begin in the first half of next year. In terms of the projections in the World Economic Outlook, the effect on projected global growth in 2001 is likely to be moderate, since developments in the third and fourth quarters of the year have a limited impact on the average growth rate for the year as a whole. In 2002, however, global growth is likely to be lower than the 3.5 percent projected here.

In sum, the downside risks identified in the main text of this World Economic Outlook have now increased, even if the economic channels are largely the same. The task for policymakers has correspondingly become more challenging, both in industrial and in developing countries. The basic requirements remain those set out in the World Economic Outlook; in particular:

  • The aggressive monetary policy response following the attack has been appropriate, and there remains room for maneuver, to varying extents, if additional action is needed. In particular, there remains room for a more aggressive monetary easing in Japan, even following the welcome steps after the September 11 attack. On the fiscal side, the automatic stabilizers should be allowed to operate. Beyond that, it is probably best to wait a little to see how events develop.

  • Given the uncertainties in the United States, other countries—notably in Europe and Japan—will have to rely more on internally generated growth. This makes it even more important to press ahead with structural reforms.

  • The weaker global outlook has clearly added to the difficulties facing emerging market countries. With markets increasingly differentiating according to policy performance, the central requirement remains to stay the course of prudent macroeconomic policies and structural reforms.

The global slowdown since early 2000 has been driven by a variety of interlinked factors, including a reassessment of corporate profitability and the associated adjustment in equity prices; the rise in energy prices in 2000, which proved more enduring than initially expected; and the tightening of monetary policy in late 1999 and 2000, particularly in the United States and the euro area, in response to rising demand pressures. Weakening global activity has been accompanied by a downturn in business and consumer confidence, starting in the United States but then spreading to Europe (Figure 1.2), a tightening of credit conditions for some key emerging markets, and heightened risk aversion. Among these factors, the boom and bust in the stock prices of information technology (IT) firms, and the associated sharp fall in IT investment and output, have played a particularly important role. As discussed in Chapter III, unsustainable financial booms have been a common feature of past technological revolutions, and have typically been associated with a significant degree of over investment in the sector concerned, and an ensuing correction. However, the latest episode has been distinguished by the globalization of IT production, so that the decline in IT spending—which as yet shows little sign of abating—has had a particularly widespread impact.

Figure 1.2.
Figure 1.2.

Selected European Union Countries, Japan, and United States: Indicators of Consumer and Business Confidence1

After falling sharply from late 2000, confidence in the United States has begun to stabilize. In Europe, business confidence has weakened, and recently consumer confidence has turned down.

Sources: Consumer confidence for the United States, the Conference Board; for European countries, the European Commission. Business confidence for the United States, the U.S. Department of Commerce, Purchasing Managers Composite Diffusion Index; for European countries, the European Commission; and for Japan, Bank of Japan.1Indicators are not comparable across countries.2Percent of respondents expecting an improvement in their situation minus percent expecting a deterioration.

In response, policymakers have generally moved promptly to ease macroeconomic policies; nonetheless, given the size of the shocks, the impact has inevitably been substantial. Moreover, given the global nature of these shocks, as well as the increased trade and financial linkages among countries, their impact has been more rapid and widespread than many expected (and in a number of cases has been exacerbated by country specific factors). The net result is that growth has slowed in almost all major regions of the world, accompanied by a sharp decline in trade growth (Figure 1.3). While the latter has been evident in all regions, the falloff has been particularly steep for many Asian emerging markets, reflecting their heavy dependence on IT trade.

Figure 1.3.
Figure 1.3.

Global Output, Industrial Production, and Trade Growth

(Percent change from four quarters earlier)

Growth in output and industrial production has weakened in almost every region of the globe, accompanied by a sharp slowdown in the growth of trade flows.

Sources: Central banks and ministries of finance; and European Central Bank, Monthl Bulletin.1Canada, euro area, Japan, United Kingdom, and United States.2Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.3Hong Kong SAR, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan Province of China, and Thailand.4Czech Republic, Hungary, Israel, Poland, Russia, Turkey, Pakistan, and South Africa.5Defined as exports plus imports of the relevant region.

Financial markets have remained volatile, partly reflecting rapidly changing expectations about the duration and depth of the slowdown and recently rising risk aversion and broad-based flight to quality following the terrorist attack. In mature markets, equity prices rallied temporarily in April and May, but have since fallen significantly as incoming news on corporate profitability remained weak and growth prospects deteriorated, with equity markets in all major industrial countries falling sharply following the events of September 11 (Figure 1.4); yields on government bonds broadly mirrored these developments, but have risen lately at long maturities. With short-term rates declining in response to cuts in official rates in most industrial countries, yield curves have generally steepened, albeit to varying extents. In currency markets, the U.S. dollar continued to appreciate in nominal effective terms through July, apparently reflecting continued confidence in the relative strength of the U.S. economy, while the yen and the euro remained relatively weak.3 In August and September, however, as concerns about U.S. growth prospects increased, the dollar depreciated moderately against most major currencies, with the euro returning close to its level against the dollar at the beginning of the year.

Figure 1.4.
Figure 1.4.

Financial Market Developments

Equity markets and interest rates have fallen significantly since 2000, including in the aftermath of the terrorist attack on September 11, 2001. Despite some recent strengthening, the euro and the yen remain relatively weak against the U.S. dollar.

Sources: Bloomberg Financial Markets, LP; European Central Bank; IMF Treasurer’s Department, Nikkei Telecom; and WEFA, Inc.1Average of the month.2Three-month deposit rate; euro area data prior to January 1999 reflect Germany.3Ten-year government bond rate. To December 1998, euro area yields are calculated on the basis of harmonized national government bond yields weighted by GDP. Therefore, the weights are nominal outstanding amounts of government bonds in each maturity band.

In emerging markets, financial developments have been influenced by mature markets, but also by country-specific factors. During the first half of 2001, the EMBI+ spread remained volatile, with the positive effect of lower U.S. interest rates offset by rising risk aversion and in some cases deteriorating economic fundamentals. While spreads for most emerging market countries declined through June, there were substantial increases in Argentina—which also affected Brazil—and Turkey. As difficulties in Argentina and Turkey intensified in July, their spreads widened sharply, with spillovers to other emerging markets, particularly in Latin America. But overall, contagion effects have so far proved moderate, in part because increasingly risk averse investors had already tended to diversify away from all but the highest quality emerging market credits, and also because of the relatively low level of leverage in financial markets. As the World Economic Outlook went to press, high yield and emerging market spreads had risen markedly following the terrorist attack, reflecting a broad-based flight to quality, accompanied by significant declines in emerging equity markets. After a weak first quarter, gross financing flows held up relatively well in the second quarter, but have subsequently fallen again. For 2001 as a whole, net capital flows to emerging markets are projected to turn negative for the first time since the mid-1980s (Table 1.2).4 Moreover, given the sharp deterioration in financing conditions since June and rising global risk aversion, there are downside risks to this outlook.

Table 1.2.

Emerging Market Economies: Net Capital Flows1

(Billions of U.S. dollars)

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Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing. Emerging markets include developing countries, countries in transition, Korea, Singapore, Taiwan Province of China, and Israel.

Because of data limitations, “other net investment” may include some official flows.

A minus sign indicates an increase.

The sum of the current account balance, net private capital flows, net official flows, and the change in reserves equals, with the opposite sign, the sum of the capital account and errors and omissions.

Includes Korea, Singapore, and Taiwan Province of China.

Includes Indonesia, Korea, Malaysia, the Philippines, and Thailand.

Includes Israel.

During the first five months of 2001, headline inflation continued to rise in most advanced economies (with the important exception of Japan), driven by the earlier sharp increase in energy prices, and—particularly in Europe—rising food prices due to animal diseases and bad weather. Core inflation also rose, but in most countries is still moderate. During the rest of the year, oil and food prices are expected to fall back (Appendix I) while underlying inflationary pressures are expected to remain modest, reflecting weak demand, increasingly competitive product markets, and the improved anti-inflation credibility of central banks in the past decade (see Box 1.2 on page 13). As a result, headline inflation in almost all advanced economies is projected to decline significantly by 2002 (Table 1.3), and recent inflation data for most advanced countries appear consistent with this expectation. Inflation could in some circumstances become more worrisome—for instance, if in the euro area higher headline inflation fed through into 2002 wage rounds, or if in the United States the economy were to rebound significantly more rapidly than expected, or if underlying productivity growth were to slow. Nonetheless, at the present juncture, the balance of risks still lies clearly on the side of weaker activity rather than higher inflation.

Table 1.3.

Advanced Economies: Real GDP, Consumer Prices, and Unemployment

(Annual percent change and percent of labor force)

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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.

Overall, the current conjuncture is characterized by unusually large uncertainties and risks, both in advanced and emerging market economies. First, with the broadening of the economic slowdown, there is now no major region providing support to global activity. This has increased the vulnerability of the global economy to shocks, and heightened the risk of a self-reinforcing downturn whose consequences could prove difficult to predict, given the progressively stronger and more complex linkages across economies (Chapter II). Second, slowing growth will put increasing pressure on financial and corporate sectors in a number of countries, notably Japan where banks remain exposed to equity and bond markets. Third, while emerging markets benefit from lower global interest rates, financing conditions remain volatile, partly reflecting continued uncertainties in Argentina and Turkey. The implications of a serious slowdown in industrial countries for emerging market financing, whose structure has increasingly shifted from bank finance to equity and bond markets during the 1990s, have also yet to be seen. Finally, as already mentioned, the terrorist attack on the United States on September 11 exacerbates all of these risks and adds a further one, namely uncertainty and volatility in oil prices.

The outlook needs also to be viewed against the backdrop of the substantial imbalances that have developed in the global economy during the recent expansion, including the large U.S. current account deficit matched by relatively strong current account positions in a number of other major countries (Table 1.4); the apparent overvaluation of the U.S. dollar, particularly vis-à-vis the euro; low U.S. personal savings rates; and equity markets that—at least prior to the terrorist attack—still appeared richly valued by historical standards. In particular, the question arises whether short-term developments and policies are likely to be consistent with an orderly resolution of these imbalances, or whether they could actually make them worse, increasing the risk of a larger and more disorderly adjustment later on. Such concerns are heightened by the weakening of growth outside the United States and—partly associated with that—the present constellation of exchange rates. Notwithstanding recent developments, the continued strength of the U.S. dollar against the euro may inhibit recovery in the United States while reducing the scope for monetary policy easing in the euro area, constraining a desirable rebalancing of external and domestic sources of growth in both areas and making an orderly resolution of global imbalances more difficult.

Table 1.4.

Selected Economies: Current Account Positions

(Percent of GDP)

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Calculated as the sum of the balances of individual euro area countries.

As discussed in several recent issues of the World Economic Outlook, an important factor underlying these imbalances appears to have been a belief that the underlying rate of productivity growth in the United States has increased relative to other countries, making the United States a relatively more attractive environment for new investment. This, in turn, contributed to larger capital inflows, rising equity prices, and an appreciation of the U.S. dollar, which led to a widening U.S. current account deficit and a drop in U.S. personal saving. To the extent that these imbalances have been driven by such factors, their evolution in the period ahead—and the risks associated with them—will depend importantly on how expected and actual productivity growth unfolds in the United States and elsewhere. Clearly, this issue is—and will no doubt remain—subject to debate and considerable uncertainly. In the United States, some part of the recent increase in actual productivity has likely been cyclical, but a portion may well be more enduring in nature, reflecting the benefits of the information technology revolution (Chapter III). In most other advanced countries—with Australia being an important exception—there is much less evidence of an underlying increase in productivity, suggesting that developments in the future will depend importantly on progress with structural reform.

Despite these risks and uncertainties, there remains a reasonable prospect of a pickup in global growth in the coming period, although more slowly than earlier envisaged, especially following the terrorist attack. Most importantly, since the beginning of the year macroeconomic policies have been eased in most advanced countries, and in the United States in particular there is now substantial stimulus in the pipeline. At the same time, activity is likely to be bolstered by the abatement of oil and food price shocks, which appear to have had a particularly important effect in the euro area; the completion of ongoing inventory adjustments; and, as past overinvestment is worked off, a recovery in the IT sector (although the timing of this remains very uncertain). Against this background, in the IMF’s baseline scenario, GDP growth in the United States and the euro area is projected to begin to strengthen mildly in the coming period, although the pace will be dampened by the lagged impact of past wealth losses on consumption, as well as by the continued unwinding of IT overinvestment, particularly in the United States, and the impact of the terrorist attack. Stronger demand in industrial countries, along with the pickup in the IT sector, would support improved growth in emerging market economies and a gradual improvement in external financing conditions. As a result, global growth in 2002 is projected to increase to 3.5 percent, although—especially if the timing of recoveries in major countries is delayed or confidence weakens sharply as a result of the terrorist attack—there are downside risks to this projection.

In this baseline scenario, the moderation in global imbalances in the short-term would be limited, with the U.S. current account deficit falling only modestly in 2001–02. Provided that the future growth outlook in the United States was still perceived as solid, there would be a reasonable prospect that capital inflows would be sustained. Thereafter, provided structural reforms to boost potential growth and productivity in Japan and the euro area are put in place, investment opportunities outside the United States are likely to become increasingly attractive. Capital flows to the United States, and the U.S. dollar, would then fall back, ideally in a gradual fashion, consistent with an orderly resolution of global imbalances.5

How Much of a Concern Is Higher Headline Inflation?

With global growth weakening, how far should monetary policy be eased to support activity? The scope for such monetary easing must be weighed against both near-term inflation prospects and longer-term concerns about anti-inflationary credibility. A current complication is that inflation developments have been obscured by price shocks that have boosted “headline” (or overall) inflation rates in many countries (including the euro area and United States), despite slowing real growth. Abstracting from these shocks, inflationary pressures appear to have remained subdued. Should policymakers be concerned about rising headline inflation, or instead focus on underlying price measures?

The argument for focusing on core as opposed to overall inflation is based on what drives prices across markets.1 In some markets, especially for commodities, sharp price movements tend to be associated with supply and demand developments that are specific to those markets without reflecting generalized inflationary pressures. Labor markets, in contrast, tend to adjust sluggishly in response to broader-based imbalances between aggregate supply and demand. Hence, shocks specific to commodity markets will tend to generate one-off changes in the price level, while labor market imbalances may be associated with much longer-lived changes in prices.

There are also arguments for looking at overall inflation. Firstly, price level shocks can lead to higher wage growth if the inflation expectations of wage-setters are affected. Secondly, what appear to be isolated price shocks may instead reflect general conditions of excess demand that show up first in markets where prices are flexible. These phenomena were apparent in the 1970s, when price shocks in specific markets were accompanied by an acceleration in underlying inflation that persisted until the 1980s.

Regression Results for Overall and Core CPI Inflation

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Absolute values of t-statistics in parentheses, adjusted for MA (12) error terms. Constant terms in the regressions have been suppressed.

Since then, the anti-inflationary credibility of monetary policymakers has become better established, as they have responded firmly to forestall any signs of emerging pressures. With the enhanced credibility of policy, specific price shocks, such as the oil price surge during the Gulf War, have not triggered generalized inflation. Indeed, during the 1990s, industrial countries have enjoyed the lowest sustained inflation rates since the 1950s. Such anecdotal evidence suggests that price shocks should be of less concern now than at times in the past.

Statistical evidence on the relationship between overall and core inflation also supports the view that price shocks are now of less concern. During 1965–82, the dominant factor explaining U.S. inflation (either overall or core) was past overall inflation, while the effect of lagged core inflation was actually negative (see the Table). In other words, price shocks that drove a wedge between overall and core inflation tended to cause long-lived increases in both measures of inflation. The results for 1983–2001 are quite different—the parameters on both lagged inflation rates are small and statistically insignificant, with the borderline exception of that on lagged core inflation in its own equation. While data limitations for the euro area preclude a comparison over the same time periods, over a relatively short 1997–2001 sample, lagged overall inflation in the euro area again plays a much smaller role than during the 1965–82 period for the United States.

What lessons can be drawn for monetary policy from these results? The apparent change in the behavior of inflation since the early 1980s supports downplaying shocks to headline prices. Moreover, indicators of inflation expectations suggest that recent price shocks will have temporary effects: consensus forecasts point to significant declines in U.S. and euro-area inflation next year; market forecasts of longer-term inflation implicit in index-linked bond yields remain subdued (see the Figure); and other traditional inflation indicators, such as gold and commodity prices, have not suggested inflationary pressures. At the same time, the change in the behavior of inflation since the early 1980s also reflects changes to the policymaking process, in particular the determination of central banks to contain inflation by resisting any second-round impacts of temporary price shocks. The continued credibility of such policies depends on the willingness to tighten policies given any signs that price shocks are fuelling underlying inflationary pressures.

uch01bx02fig01

Inflation Expectations Derived from Index-linked Bonds

(Percent)

Sources: Bloomberg Financial Markets, LP; and IMF staff calculations.
1Core inflation is defined here as the overall CPI less food and energy prices to abstract from temporary supply shocks in these markets. This measure can still be influenced by price shocks. For instance, the weak euro has boosted import prices in the euro area, while the reverse has been true in the United States.

However, given the risks already described, there remains a significant danger of a worse outcome. For instance, if U.S. productivity growth were to disappoint, and overinvestment during the recent boom turned out to have been more extensive and widespread than presently believed, equity markets in the United States could weaken markedly, accompanied by a sharp fall in fixed investment and in private consumption (which has so far remained relatively resilient). As discussed in Appendix II, this could result in a much deeper and more protracted global downturn—similar to that experienced in the early 1980s and early 1990s—especially if also accompanied by continuing structural weaknesses and consequently weaker-than-projected productivity growth in Europe and Japan. There would also be a possibility of substantial financial market turbulence, including in some circumstances a possible abrupt decline in the value of the U.S. dollar. The impact on developing countries would be substantial, including through a further deterioration in external financing conditions; this could both aggravate and be aggravated by country-specific risks.

In this environment, policymakers across the globe face a particularly challenging task. With the slowdown becoming increasingly synchronized, and significant downside risks, short-term macroeconomic policies need to remain supportive of activity and confidence, and in some cases a more proactive stance would be desirable:

  • In the United States, recent tax cuts and monetary policy easing—along with the higher expenditures in the wake of the terrorist attack—should provide support to activity in the second half of 2001 and beyond, but this has been partly offset by the strength of the U.S. dollar. The U.S. monetary authorities have already cut rates substantially, although some limited room for further reductions remains were the outlook to weaken significantly further.

  • In Japan, the scope for further macroeconomic policy stimulus remains limited. Recent monetary easing is welcome, but there remains room to exploit the flexibility afforded by the new monetary framework more aggressively, even if this results in some depreciation of the yen. On the fiscal side, a modest supplementary budget is appropriately being considered, as the authorities should avoid too rapid a withdrawal of stimulus (Table 1.5).

  • In the euro area, the recent cuts in interest rates were appropriate. If the outlook were to weaken materially further, provided that inflation developments remain favorable, there would be scope for additional easing. Tax cuts in some countries are providing modest support to activity, and automatic stabilizers should be allowed to operate fully to buffer weaker activity.

Table 1.5.

Major Advanced Economies: General Government Fiscal Balances and Debt1

(Percent of GDP)

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Note: The methodology and specific assumptions for each country are discussed in Box A1.

Debt data refer to end of year; for the United Kingdom they refer to end of March.

Percent of potential.

Data before 1990 refer to west Germany. For net debt, the first column refers to 1988–94. Beginning in 1995, the debt and debt-service obligations of the Treuhandanstalt (and of various other agencies) were taken over by general government. This debt is equivalent to 8 percent of GDP, and the associated debt service to 32 to 1 percent of GDP.

Includes one-off receipts from the sale of mobile telephone licenses equivalent to 2.5 percent of GDP in 2000 for Germany, 0.5 percent of GDP in 2001 for France, 1.2 percent of GDP in 2000 for Italy, and 2.4 percent of GDP in 2000 for the United Kingdom.