Growing consensus on softening growth

Views about the world economy have been changing rapidly in recent months. A month ago, there was disagreement on which way the global economy was going. Today, there is increasing consensus about a softening of world GDP growth. Global growth had accelerated slightly, from 4.75% in 2005 to 5% in 2006. It is now widely believed that this will slow to 4% in 2007.

The biggest change in outlook is in the US, which is expected to slow from 3.5% in 2006 to 2.25% in 2007. The Economist believes a sharp slowdown in the American economy could be offset by increasing consumer demand in Asia. However, there is little doubt that US GDP growth still matters.

One of the main reasons for the change in outlook is the change in the US housing market. In the past two months, conditions have rapidly deteriorated on this front. After roughly a decade over which prices doubled, a drop in prices has taken place. This is the first time since 1991 that US house prices have declined. The inventory of unsold housing has swelled, and popular fears about house prices have been fuelled by media focus on ?the housing meltdown.?

Hence, a further decline in house prices is very likely. The full impact of the evolution of these house prices on consumption and demand in the US will play out in the coming quarters. The fall in new construction means lower demand for furnishings, consumer durables like refrigerators, washing machines, and air conditioners. The decline in housing prices is also expected to have a wealth effect that would lead to lower consumption demand. In addition, higher interest rates mean more money goes out in EMIs.

The question being asked today is: what will happen to US GDP growth and world GDP growth in the aftermath of this rapid turnaround in conditions on the US housing market? The answer is not entirely clear. There are many conflicting signals. For example, the sharp drop in crude oil prices has given US consumers fresh spending power. It could serve to improve the US current account balance, thus reducing the size of the ?global imbalances? problem. On the other hand, lowered commodity prices could reflect sombre expectations about future growth.

Second, while the newspapers are full of bad news on US housing, the stock market index of home construction companies has improved quite a bit in recent weeks. Third, the US has received another piece of good news about its government deficit, which shrank from a frightening 4% of GDP in 2004, to 2% of GDP this year, despite the enormous cost of fighting two wars. This reflects buoyant GDP growth and, thus, tax collections.

Another piece of the puzzle is interest rates. The key factor that will shape the behaviour of the Fed on whether to raise interest rates or not is US inflation data. For most of 2006, US inflationary expectations have exceeded 2%, which Ben Bernanke and the Fed consider the highest acceptable inflation level for the US economy. The Fed can accommodate inflationary expectations of above 2% if it is felt that these reflect transitory fluctuations of oil prices. But if inflationary expectations persist above 2%, or accelerate, the Fed will be forced to raise rates.

The last piece of the global puzzle remains the question of ?global imbalances.? Chinese reserves crossed a trillion dollars, and there appears to be a slight acceleration in the rate of appreciation of the renminbi. Economists are criticised for crying wolf on this problem over many years. But it remains a basic difficulty underlying the outlook for the global economy. The 4% growth anticipated in world GDP is clouded by the possibility of unpleasant events as these global imbalances are resolved.

Those who expect a ?soft landing? believe GDP growth will decrease, with a consequential easing of inflationary pressures in the US, thus removing the possibility of rate hikes by the Fed. Interestingly, while the US bond market appears to believe that future growth will be poor?the long interest rate is low, on the other hand, the US equity market appears to believe that future growth will be strong?stock market valuations are high. In coming months, this contradiction will undoubtedly be resolved in one direction or the other.