Thursday, September 07, 2006

Financial Times Editorial - Containing the cracks in the world economy

Financial Times Editorial - Containing the cracks in the world economy
Copyright The Financial Times Limited 2006
Published: September 7 2006 03:00 | Last updated: September 7 2006 03:00

Is the glass half full or half empty? According to a confidential International Monetary Fund report seen by the Financial Times, the glass looks full but is developing some alarming cracks. The world's policymakers now face a difficult task in trying to stop them spreading. The IMF's baseline projection forecast is excellent: world economic growth up a quarter of a percentage point to 5.1 per cent in 2006 and 4.9 per cent in 2007, continuing recent bumper growth. Yet the IMF is investing more emphasis in gloomier scenarios. That should not be a surprise: the cyclical recovery after the downturn of 2001 cannot last forever.

So the fund explores two key risks, one on the demand side and one on the supply side. The demand side risk is familiar: a sharp US slowdown, probably triggered by a tottering housing market. The IMF already forecasts that the weaker housing outlook will slow even its baseline forecasts, but a nastier house price crash, surely a possibility, knocks another percentage point off the fund's growth forecasts.

It was with this prospect in mind that the Federal Reserve - sensibly, in the view of the IMF - stopped raising interest rates. Yet the second risk makes it very hard for the Fed, and other central bankers, to make the right decisions. That risk is of rising inflationary pressures as the world economy runs out of spare capacity and productivity growth slows down. There are distinct signs of this with high commodity prices, headline inflation above comfort levels and inflationary expectations rising too.

Central bankers have earned a great deal of credibility over the past 25 years, but it is not infinite. The Federal Reserve managed not to provoke expectations of inflation despite years of cheap money, but those days may be over as the market decides that inflation was not dead, just resting.

What happens now? If there is a productivity slowdown and an outbreak of inflation, the Federal Reserve will wish that it had raised rates after all. As the FT warned, the cost of the pause in interest rate rises, however justifiable, might be higher rates later. The IMF concurs. It is a tricky balancing act and the twin pressures on the supply and the demand side will do nothing to make it easier. Neither will the vast borrowing of the US nation.

All the while, as the IMF rightly warns, other opportunities are being squandered. Europe still needs structural reform: the US may fear a productivity slowdown but the eurozone has enjoyed little productivity growth anyway in recent years. And governments are running out of time to make provision for their ageing populations.

The risks that the IMF is analysing can be summarised in a single word: stagflation. It may not happen and, even if it does, the IMF fears something much milder than the woeful experience of the seventies. That is not entirely comforting.


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