Globalization & Monetary Policy Institute
International Economic Update
The Global Outlook: The Good, the Bad and the Ugly
September 22, 2011 | Update in PDF
The world economy has been slowing gradually since 2010 due to a weakening recovery in advanced economies. The outlook for inflation remains stable, although signs of overheating are creeping up again in emerging economies as core inflation trends upward.
Advanced economies have maintained extremely accommodative monetary policy stances to stimulate growth. As a whole, emerging economies have tightened monetary policy (and even lending) to combat inflation and rapid asset price appreciation; some have also relied on capital controls to manage their exchange rates and promote export-led growth. Expansionary fiscal policies have weakened the state of public finances in most advanced economies. These fiscal challenges have prompted varied efforts to raise taxes and cut spending to curb debt.
While the growth slowdown is expected to be temporary, risks are heightened. Fiscal consolidation, the euro-area sovereign debt crisis and potential spillovers to advanced economies’ financial system pose significant downside risks to the global outlook.
The Good: Emerging Economies’ Robust Growth, Advanced Economies’ Stable Core Inflation
Global growth continues at a dual pace, with emerging economies outperforming advanced economies. For the remainder of 2011 and in 2012, emerging-economy annual gross domestic product (GDP) growth is expected to average 7 percent. Advanced economies are expected to average 2 percent growth over the same period (Chart 1A).
Commodity price booms in 2008 and 2010 have affected headline consumer price index (CPI) inflation in advanced and emerging economies. However, core inflation, a measure of price changes that excludes food and energy due to their volatility, has grown at a stable 1 percent annual rate in advanced economies despite large swings in headline CPI. Monetary policy in these economies has remained largely accommodative. In turn, core CPI inflation appears to be increasing in emerging economies (Chart 1B), which has forced their monetary authorities to increase policy rates partly to ward off inflation.
The Bad: Broad Slowdown, Deteriorating Conditions in Advanced Economies
Purchasing Managers Index (PMI) data show that both advanced and emerging economies have lost momentum in the manufacturing and service sectors, suggesting that the recent slowdown is more broadly based than previously thought. The J.P. Morgan Global Composite PMI fell from a peak of 59.2 in February to 51.5 in July. Over the same period, the Global Manufacturing PMI fell from 57.4 to 50.1, just above contractionary territory (Chart 2).
Signs of deterioration in the euro area have mounted since July. Money market spreads for the euro have risen above their average prior to the collapse of Lehman Brothers, but this increase has not fed through to other advanced-economy money markets (Chart 3). Stock markets around the world—not just in the euro area—have also reflected the financial stress and have suffered substantial declines. Even the euro–U.S. dollar exchange rate has flagged in the last month. These financial market strains pose a significant risk to the global outlook because declines in financial wealth could further restrain private consumption and weaken the demand for U.S. exports abroad, while borrowing cost increases could affect the ability of firms to fund investment and expand the workforce.
The Ugly: Euro-Area Debt and Financial Crises Pose Major Downside Risks
The European Banking Authority released its latest bank stress tests on July 15. Greece’s struggle to meet fiscal and structural reform targets prompted the International Monetary Fund, the European Commission and the European Central Bank to suspend the fifth review of the country’s fiscal consolidation program on Sept. 2. These developments have acted as bad omens for financial markets, but doubts over the state of the peripheral EU were already pronounced in 2010, as seen in the skyrocketing costs of insuring bank debt and even sovereign debt with credit default swaps (CDS) (Charts 4A and 4B). What is new is that bank and sovereign CDS spreads for core EU countries and the U.S. have climbed as information about their exposure to peripheral Europe and the size of potential losses has prompted fears of a financial spillover from the EU periphery to other advanced economies.
The spillover risk stems in part from the level of interconnectedness of the banking system within Europe and the U.S. (Chart 5). While U.S. banks do not directly hold large amounts of foreign claims from the EU periphery (and only small amounts from Greece), they are exposed to assets from France, Germany and the U.K., which, in turn, hold over $1.78 trillion in public and private claims from the EU periphery (in particular from Italy and Spain). Public claims are at most 30 percent of total foreign claims reported (and often less), suggesting that exposure to private-sector claims is of greater material importance for core European, U.K. and U.S. banks than exposure to peripheral EU sovereign debt. Additionally, nonbank financial institutions such as insurance companies and pension and mutual funds hold significant amounts of peripheral EU debt, making the repercussions and scale of default presumably larger and more uncertain.
Growing Risks to the Global Outlook
Available forecasts for global growth suggest the ongoing slowdown will be temporary, but the outlook must be tempered by increasing risks related to fiscal and financial challenges in advanced economies and the worsening euro-area debt crisis. While core inflation remains within the prerecession range for advanced economies, rising headline and core inflation have required monetary authorities in emerging economies to lift policy rates and, in some instances, curb domestic lending and international capital flows. Advanced economies have continued to underperform their emerging counterparts and face stronger headwinds from the EU periphery and from rising public indebtedness. Governments’ response to these challenges will likely determine global economic performance in the medium term.
—Enrique Martínez-García and Payton Odom
About the Authors
Martínez-García is a senior research economist and Odom is a research analyst in the Research Department of the Federal Reserve Bank of Dallas.