In the United States, durable goods orders and household spending were up going into the third quarter, and profit margins are ample, albeit declining. However, the housing sector is set to exert a longer and more potent than expected drag, and confidence has weakened. As a result, GDP growth is projected to fall distinctly below potential during the second half of this year, following the strong rebound in the second quarter. All in all, our growth estimates may err on the upside, since it has not yet been possible to fully evaluate the negative impact of credit market turbulences on economic activity. In any event, consumer resilience will be tested by mortgage rate resets, tighter credit standards, weaker collaterals and slower job creation.
Contrasting with developments across the Atlantic, activity decelerated in the second quarter in the euro area at large and in most of its economies. While consumer confidence is fairly elevated, consistent with receding unemployment, retail sales have remained subdued. Business sentiment has been dented by the financial turmoil, but expectations are still fairly upbeat. Accordingly, growth should pick up to around potential in the euro area, including the three larger economies, in the second half of the year. Nevertheless, the peak of the euro area growth upswing now seems to lie behind.
Despite a deceleration in the course of the first half of 2007, the expansion in Japan is set to continue. Although it weakened in the second quarter, business investment should be an important driver, with high capacity utilisation and profits. Household consumption has slowed but should be supported going forward by much-improved labour market conditions. In addition, the negative contribution from stockbuilding in recent quarters suggests that in the near future inventory accumulation should add to growth.
The major central banks generally face an economic outlook characterised by scant spare capacity and unemployment rates close to or below their structural levels, as well as high energy prices and rapidly rising food prices. Outside Japan, inflation rates – despite recent easing in some cases – are still at the high end of what is consistent with price stability. At the same time, they are confronting risks to financial stability, which have prompted them to step in with large but temporary injections of liquidity. An important requirement in this respect is to avoid a situation where excess risk taking would be bailed out. Hence, besides short-run liquidity management, monetary policy and interest rate setting should continue to focus on prospects for inflation and economic activity. In that light, there may be a case for some easing in the US federal funds target rate, following the August cut in the discount rate. In the euro area, rising underlying inflation pressures, partly related to the evaporation of labour market slack, would seem to warrant some further tightening once financial market conditions have steadied and the recovery develops as expected. In Japan, it is advisable to wait for market volatility to quiet down and for a durable end to deflation before hiking the policy rate further.
Recent developments have revealed serious imperfections in the functioning of US housing markets and, more broadly, in credit markets worldwide. Markets will learn from recent mistakes through the usual “learning-by-doing” process. Such progress may nonetheless be enhanced by improved regulation. There may be a need, for instance, for more encompassing supervision of US sub-prime mortgage markets, with greater attention to non-bank originators which have often evaded effective scrutiny. As well, there may be a case for a more active fight against predatory lending, including through better disclosure and education. More transparency also seems to be called for in credit markets, where securitisation has made risk assessment increasingly difficult for many investors, leading to widespread loss of confidence. Given the swathe of re-ratings in recent months, more pugnacious and inquisitive rating agencies could help bring this about.
On the fiscal front, revenue buoyancy has generally continued to surprise on the upside, not least as a lagged reflection of high corporate profits, rapid growth in high incomes and rising asset prices. In some countries, including the United States and Germany, the windfalls translate into faster-than-budgeted consolidation. In many others, however, further efforts are called for in order to regain fiscal room for manoeuvre. Specifically, with rapidly ageing populations, pension and health care system reforms are a matter of urgency."
